A recent Tax Court decision clarifies the issue of trader versus investor tax status for hedge funds. A fund that trades securities must be categorized as either an investor fund or a trader fund, with the latter defined as a fund that is engaged in the trade or business of trading securities.
Two main income tax differences exist between trader funds and investor funds. While trader funds often elect to mark to market their investments for tax purposes, reporting gains and losses as ordinary, investor funds typically do not mark to market and report capital gains and losses only upon a realization event. Another difference relates to the treatment of fund expenses. A trader fund generally treats fund expenses, such as management and professional fees, as ordinary business deductions under section 162. In contrast, an investor fund generally treats these expenses as miscellaneous itemized deductions under section 212. For nearly all individual investors in a fund, treating fund expenses as section 162 business expenses rather than miscellaneous itemized deductions provides a very substantial tax benefit. Most individual investors do not obtain a tax benefit from section 212 expenses.
There is no clear statutory or regulatory definition of a trade or business in the context of hedge funds. The factors courts use to determine whether a fund qualifies as a trade or business include (1) the volume and frequency of trading, (2) whether the fund trades only for its own account or for or with customers, and (3) whether the fund typically looks for profits from short-term price movements or long-term appreciation.
What the case actually held
In its Aug. 28, 2013, decision in Endicott v. Comm’r, T.C. Memo 2013-99, the Tax Court ruled against a taxpayer who claimed he was a dealer or trader engaged in a trade or business, finding that the taxpayer was merely an investor. The taxpayer had developed a strategy involving the purchase of equity investments and the writing of covered call options. He performed 204 trades in 2006, 303 trades in 2007, and 1,543 trades in 2008. The taxpayer executed trades on 75 days in 2006, 99 days in 2007, and 112 days in 2008. His average holding period for an equity position was 35 days throughout this three-year period. The taxpayer’s equity purchases amounted to $7 million in 2006, $15 million in 2007, and $16 million in 2008.
The Tax Court looked mainly to the regularity of trading activity (or lack thereof) in reaching its decision. Even though the dollar amounts were substantial, the court focused on the number of days the taxpayer actually executed trades. The court ruled that the number of trades in 2006 and 2007 was insubstantial. Although a substantial number of trades occurred in 2008, the court focused on the fact that the trades occurred on only 112 days. Finding that this was not trading on “an almost daily basis,” the court rejected the taxpayer’s assertion that his activities had achieved the status of a trade or business.
Based on the court’s explanation of its decision, it appears that an individual taxpayer (or a group of individuals in a fund), trading for the taxpayer’s own account with a similar strategy, could potentially achieve trade or business status by executing approximately 1,600 or more trades per year, involving $16 million or more of equity positions, on a per taxpayer basis, with trading occurring on close to 246 days–the maximum number of trading days in a year.
Hedge funds should be conscious of this tax court case when considering the implications of electing trader status as opposed to investor status. In addition, hedge funds should evaluate their activities carefully in light of this case. There is no assurance that, even if the above-mentioned levels of trading were attained, a court might not find other factors leading it to deny trade or business status.