A Trader's Guide to Mark-to-Market Accounting and Structuring Your Trading Business

Published: February 15, 2024 • Stocks, Crypto & NFTs

Introduction
For active traders, navigating the complex world of tax laws and accounting methods can be a daunting task. One of the most important decisions a trader can make is whether to elect the mark-to-market (MTM) accounting method under Section 475(f) of the Internal Revenue Code. This election can have significant implications for how a trader’s gains and losses are reported and ultimately how much they owe in taxes.

In this guide, we’ll dive into the criteria for qualifying as a trader for tax purposes, the pros and cons of the MTM election, the process for making the election, and considerations for structuring your trading business as a legal entity such as an LLC. While this guide provides an in-depth overview, it’s important to consult with a qualified tax professional about your specific situation before making any decisions.

Understanding Trader Tax Status
Before we delve into MTM accounting, it’s crucial to understand what qualifies a taxpayer as a “trader” in the eyes of the IRS. Trader tax status is a tax classification that affords certain benefits, such as the ability to deduct trading-related expenses and elect MTM accounting. However, the IRS has not provided a bright-line test for what constitutes a trader. Instead, it looks at a taxpayer’s trading activity and applies a set of general principles.

Factors that indicate trader tax status include:

  1. Substantial Trading Activity: Traders should have a high volume of trades and a high dollar amount of trades. While there’s no specific threshold, the IRS has indicated that “hundreds of trades” in a year would be a reasonable indicator.
  2. Continuous and Regular Trading: Trading should be continuous throughout the year, with minimal days without trades. Sporadic or intermittent trading is less likely to qualify.
  3. Intention to Profit from Short-Term Market Movements: Traders aim to profit from short-term market fluctuations, rather than long-term appreciation. Holding periods are typically short.
  4. Trading as Primary Income-Producing Activity: For many traders, trading is their main source of income or a major focus of their business activity.
  5. Significant Time Devoted to Trading: Traders often spend a substantial part of their day researching, analyzing, and executing trades.

These factors are weighed holistically, and no single factor is determinative. However, the more your activity looks like a full-time trading business, the stronger your case for trader tax status.

It’s important to note that trader tax status is not a formal election or something you apply for with the IRS. Rather, it’s a factual determination based on your actual trading activity. If you meet the criteria, you can file your taxes as a trader. However, it’s wise to keep detailed records of your trading activity and time spent on trading-related research and analysis to substantiate your position in case of an audit.

Benefits and Drawbacks of Mark-to-Market Accounting
Once you’ve determined that you qualify for trader tax status, the next decision is whether to make the mark-to-market election. Under the default realization accounting method, gains and losses on securities aren’t recognized until the securities are sold or otherwise disposed of. If a security is held for more than a year, the gain or loss is long-term capital gain or loss. If held for a year or less, it’s short-term capital gain or loss.

Under MTM accounting, traders treat their securities as if they were sold for fair market value on the last day of the year. All gains and losses, realized or unrealized, are treated as ordinary income or loss. This can have significant implications:

  1. Ordinary Loss Treatment: Under realization accounting, net capital losses are limited to $3,000 per year as a deduction against ordinary income, with the excess carried forward. Under MTM, net losses are fully deductible against other income in the current year.
  2. No Wash Sale Rules: Wash sale rules prevent the deduction of losses on securities sold at a loss and reacquired within 30 days before or after the sale. These rules don’t apply under MTM.
  3. No Long-Term Capital Gains: Since all gains are treated as ordinary income under MTM, traders can’t benefit from lower long-term capital gains rates on positions held over a year.
  4. No Specific ID of Share Lots: Traders using MTM must use the First-In, First-Out (FIFO) method for identifying which shares are sold. They can’t use the specific identification method to strategically sell high-basis or low-basis lots.

The decision to elect MTM should be based on your trading strategy and overall tax situation. If you frequently take positions for less than a year and your trading generates net losses, MTM might be advantageous. However, if you often hold positions for more than a year or your strategy tends to generate net gains, the regular realization method might result in a lower tax bill due to the preferential long-term capital gains rates.

It’s also important to note that once you make the MTM election, you can only revoke it with IRS consent. You can’t freely switch between MTM and realization accounting from year to year based on which results in a lower tax bill.

Making the Mark-to-Market Election
If you decide that MTM accounting is right for you, the next step is to make the election with the IRS. The process is relatively straightforward but has specific timing requirements.

To make the election, you attach a statement to your income tax return for the year prior to the year you want the election to take effect. For example, if you want to use MTM accounting starting in 2024, you’d attach the statement to your 2023 return filed in 2024. If you request an extension for your 2023 return, you can attach the statement to your extension request instead.

The statement must include the following:

  1. A declaration that you’re making an election under Section 475(f)
  2. The first tax year for which the election is effective
  3. The trade or business for which you’re making the election

Here’s a sample statement:

“Under IRC Section 475(f), I hereby elect to adopt the mark-to-market method of accounting for my securities trading business. The election is first effective for tax year 2024. The election applies to my sole proprietorship securities trading business conducted through Interactive Brokers account ending in xxxx.”

Attach this statement to your Form 1040 or extension request. It’s also prudent to attach it to the return for the year the election takes effect (in this case, the 2024 return filed in 2025) to make your MTM status clear.

Once you’ve made the election, you’ll need to follow MTM accounting and reporting rules for your trading activity going forward. This includes reporting all trading gains and losses as ordinary income/loss on Form 4797 (Sales of Business Property) rather than on Schedule D.

Structuring Your Trading Business
In addition to tax accounting methods, traders should also consider the legal structure of their trading business. Many traders operate as sole proprietors, reporting trading gains and losses directly on Schedule C of their Form 1040. However, some traders choose to form a separate legal entity, most commonly a limited liability company (LLC).

The primary benefit of an LLC is liability protection. Trading can carry significant financial risks, and an LLC can help shield your personal assets from trading-related liabilities that exceed your trading account balance. For example, if you’re subject to a lawsuit related to your trading activity, only the assets of the LLC would be at risk, not your personal assets (assuming you’ve maintained proper separation between the two).

An LLC can also make for cleaner accounting and record-keeping. By having a separate bank account and credit card for your LLC, you can more easily track trading-related expenses and keep them separate from personal expenses.

However, it’s important to understand that forming an LLC doesn’t change your tax situation with regard to trader tax status and MTM accounting. A single-member LLC is disregarded for federal tax purposes, meaning the trading gains and losses flow through to your personal tax return just as they would for a sole proprietorship. The MTM election would still be made on your individual tax return for the trading activity within the LLC.

If you have other investors or partners in your trading business, you could consider a multi-member LLC or even an S-corporation or C-corporation. However, this introduces additional complexity and costs that are beyond the scope of this guide and should be discussed with a legal and tax professional.

Key Takeaways

  1. Qualifying for trader tax status depends on the frequency, regularity, and intention of your trading activity. Keep detailed records to substantiate your status. For more information, see our trader tax status guide.
  2. The mark-to-market election can be advantageous for traders with frequent trades and net losses, but it’s not right for everyone. Consider your trading strategy and consult with a tax professional.
  3. To make the MTM election, attach a statement to your prior year tax return or extension request. Once made, the election can only be revoked with IRS approval.
  4. An LLC can provide liability protection and accounting benefits for your trading business, but it doesn’t change your tax situation with regard to trader tax status and MTM. See our entity selection guide for traders for more information on choosing the right structure.
  5. Always consult with a qualified tax professional about your specific situation before making decisions about your tax accounting and business structure.

Conclusion
Tax planning is a critical component of any successful trading business. By understanding the criteria for trader tax status, the implications of the mark-to-market election, and the potential benefits of forming an LLC, traders can make informed decisions to optimize their tax situation and protect their assets.

However, the information in this guide is for general educational purposes only and should not be taken as specific tax or legal advice. Tax laws are complex and subject to change, and every trader’s situation is unique. Before making any decisions about your tax accounting method or business structure, consult with a tax professional who has experience working with traders.

With proper planning and professional guidance, you can navigate the complex world of trader taxation with confidence and focus on what you do best – trading the markets.