A Structural Critique of Trader Taxation

Abstract

Taxpayers who are securities traders are subject to unusual treatment under the tax law. Such a taxpayer is, like any other merchant or businessperson, allowed to deduct various expenses incurred in his business of trading securities but, unlike any other merchant or businessperson, is simultaneously allowed to treat gains and losses from the sale of such securities as capital, rather than ordinary, gains and losses. Such capital gains and losses may be taxed at reduced rates and subject to other different tax treatments. Since the enactment of IRC section 475(f) in 1997, traders have also been allowed to make a special election to “mark to market” gains and losses from their securities-trading activities. Making this election allows a trader to recognize gains and losses on the securities he holds as if those securities were sold at fair market value on the last business day of the trader’s taxable year, and to convert such gains or losses to ordinary, rather than capital, gains or losses.
The distinctive tax treatment of securities traders has been frequently pointed out, and various commentators have noted that, although the standards for qualifying for trader treatment are uncertain, favorable planning opportunities arise upon achieving such classification. However, the structural elements of the tax law underlying trader tax treatment and the problems created by this statutory structure have somewhat escaped scrutiny. This article approaches the unusual treatment of traders through a structural lens. By focusing on the structure of the statutory tax rules that apply to securities traders, this article explains at the outset how the unusual treatment of securities traders today has occurred due to a long-standing, legislatively created structural disjuncture at the point where the capital asset rules and the “trade or business” concept intersect. This disjuncture was created by the 1934 introduction of the “to customers” requirement into the capital asset statute, that is, the requirement that property otherwise held for sale in the ordinary course of the taxpayer’s trade or business must also be held for sale “to customers” in order to escape being treated as a capital asset. Prior to the 1934 introduction of the “to customers” requirement, the statute was essentially symmetrical in the sense that whether or not a trader–taxpayer was in a “trade or business” led to basically all of the tax consequences to that taxpayer. The introduction of the “to customers” requirement has led to a statutory scheme in which one standard determines the character of the gain or loss from the sale of securities of the trader–taxpayer, but a completely different standard (the trade or business requirement) gives rise to almost all of the other consequences with respect to deductions from gross income that apply to a trader.