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Securities Trading Not Substantial Enough

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Dec 6, 2013

The Tax Court determined in a recent case that a mortgage broker was not in the trade or business of trading securities because she did not execute enough trades.

The court upheld the IRS’s disallowance of over $800,000 in expenses claimed in connection with these activities over two tax years. It also determined that Sharon Nelson, the sole stockholder of a corporation engaged in the mortgage broker business, was liable for accuracy-related penalties.

John Zabasky, who lived with Nelson, was the chief executive officer and sole stockholder of a different corporation. Zabasky had been involved in the trading of stocks, bonds and currencies for approximately 25 years.

Nelson executed securities trades through an online investment account. Zabasky also executed securities trades through the same account.

During 2005, there were 250 available trading days. On a total of 121 days (48.4 percent of the total available trading days), 535 trades were executed through Nelson’s account. The purchases for 95 of those trades occurred in the one-week period from Sept. 27 to Oct. 3. The holding period for the securities traded on the account during 2005 ranged from one to 48 days.

Over the course of the year, there were eight periods of at least seven days when no purchases or sales occurred through the account. The 2005 trades generated $470,472.90 of net short-term capital gain for that tax year.

During 2006, there were 250 available trading days. On a total of 66 days (26.4 percent of the total available trading days), 235 trades were executed through the account. The holding period for the securities traded on the account during 2006 ranged from one to 101 days.

During 2006, there were only two trading days on which trades were executed through the account during the period from Jan. 27 to May 4, and there were seven periods of at least seven days when no purchases or sales occurred. The 2006 trades generated $36,852.28 of net short-term capital gain for that tax year.

Nelson reported her trading activities on Schedule C, Profit or Loss From Business. The IRS disallowed all of the expenses that Nelson claimed on the Schedules C – $504,217 and $303,910 for 2005 and 2006, respectively – and imposed accuracy-related penalties.

The Tax Court initially noted that it was unclear what portion of the trades for each year was in fact executed by Nelson. However, it found that, even if it were to assume that she executed all of them, she still would not carry her burden of establishing that she was a trader for both years. Specifically, the number of trades was not sufficient to constitute a “substantial” amount for either year.

The court noted that, while the amount of money involved each year (with purchases and sales ranging from $24.2 million to $32.9 million) was “considerable,” it was not determinative of whether the activity was substantial. Finally, the court found that the total number of days spent trading – and extended periods of inactivity – belied Nelson’s claim that she was a trader.

Accordingly, the court found that Nelson was not entitled to deduct under any of the expenses claimed as Schedule C expenses. The court also upheld the IRS’s imposition of accuracy-related penalties (Sharon Nelson v. CommissionerTC Memo 2013-259, Nov. 13, 2013).

The rules and regulations in the Government Contracting industry are complex and Judy Lasley does an excellent job of educating me on how to wisely calculate, set and defend rates, as well as the long-term consequences of choosing the wrong rates.

John Cates |  President and Chief Executive Officer
Global Intelligence, Inc.