Practitioners from time to time will encounter traders in securities in their practice.  Such traders hold investments for a very short period of time, often no more than minutes, looking to make money from short term movements in the price of the securities in question.

Unfortunately, doing this successfully is far from simple, and quite a few new traders find their new business is the perfect vehicle to turn a large fortune into a small one—or none.  The sale of securities normally is considered a sale of a capital asset—so if they are unsuccessful, they quickly have losses far in excess of the $3,000 per year limit on an individual claiming capital losses in excess of capital gains.

But there is an option a trader can avail him/herself of in order to have his/her gains and losses treated as ordinary rather than capital gains or losses.  The trader can make an election under IRC §475(f)(1) to use the mark-to-market method of accounting for any securities held on the last day of the taxable year.  If a trader makes that election, the gains or losses are treated as ordinary and not capital—thus, no $3,000 per year limit is imposed on deducting the losses.

The key issue is the timing of the election—a taxpayer is not allowed to wait until the end of the tax year and make this election with his/her return.  Rather, per Revenue Ruling 99-17, a taxpayer generally has to make the election:

• For a taxpayer that is required to file a tax return for the year preceding the year the taxpayer wants the election to be effective, by the unextended due date of the return for that preceding tax year, attached either to the return filed by that unextended due date or to the request for an extension of time to file the return.

• For a taxpayer not required to file return for the prior year, by placing a copy of the election in its books and records no later than two months and 15 days after the first day of the election year. [1]

The reason this election is required to be made so early in the year it will apply to is to prevent taxpayers from using the benefit of hindsight in deciding to make the election.

In PLR 202009013[2] a taxpayer asked the IRS to allow for a late election under IRC §475(f).  Since the date to make the election is set by the IRS, the IRS has the authority to grant such late election relief under Reg. §301.9100-3.  But, as the taxpayer discovered in this case, the IRS does not generally grant relief when the taxpayer does not timely make this particular election, and the agency would not do so in this case either.

Taxpayers, a married couple referred to individually as Husband and Wife, filed on Date 2 a self-prepared joint federal income tax return for Year 2 (Year 2 Return) on which they reported that Husband was engaged in a securities trading business. At the end of Year 1, Taxpayers closed all of their open trading positions.

Husband currently works full time as the treasurer of an investment trust fund company and had previously served as a tax director of a financial services company. Husband has an accounting degree as well as a law degree, along with a years of tax experience in the financial services sector. Wife is currently employed as a teacher

During Year 1 and Year 2 Husband generally traded in options. By Date 3, Taxpayers claim to have suffered losses totaling $b from an investment in Partnership, an exchange traded fund, that was treated as a partnership for federal income tax purposes. Partnership held volatility-based futures contracts. After incurring these losses, Husband continued to trade options for the remainder of Year 2, producing additional losses of approximately $c.

Taxpayers represent that shortly after suffering the claimed loss of $b from the investment in Partnership in early Year 2, Husband concluded that his securities trading activity was a trade or business for which a § 475(f)(1) election could be made. Taxpayers represent that they intended to make a mark-to-market election for Year 2. However, Taxpayers failed to make a timely § 475(f)(1) election, which was due by the due date of the federal income tax return for the taxable year preceding the year of change, without regard to extensions. In this case the election for Year 2 was due on Date 4. Husband asserts that he mistakenly assumed that the election could be made on their Year 2 Return. Husband claims he was unaware that the election had to be made by the due date (without regard to any extension) of the tax return for the taxable year preceding the year of change. Husband states that he did not discover this error until Year 3, when he began preparing Taxpayers’ Year 2 Return.

On Date 5, Taxpayers filed a § 475(f)(1) election statement for the Year 2 tax year with Taxpayers’ timely filed Year 2 Return (however, the election statement was d months too late by this time). Taxpayers reported gains and losses on a mark-to-market method on their Year 2 Return. Taxpayers also filed a Form 3115, Application for Change in Accounting Method, on Date 6. Taxpayers’ request for an extension of time to make the § 475(f)(1) election under § 301.9100 was filed e months after the due date for filing the § 475(f)(1) election.

The taxpayer essentially was asking the IRS to give him a break because he was simply not aware that this election was due so early.

The taxpayer looked for relief under Reg. §301.9100-3 to make a late election for an election where the due date is set by the IRS and not Congress, in this case the mark-to-market election under IRC §475(f)(1).  Reg. §301.9100-3(a) requires that the taxpayer asking for relief establish to the satisfaction of the IRS that:

• The taxpayer acted reasonably and in good faith, and

• The grant of relief will not prejudice the interests of the Government.

In this ruling the IRS concluded the taxpayer had not established that either test had been met.

The ruling notes that normally a taxpayer is deemed not to have acted reasonably and in good faith if facts have changed since the due date of the election that make the election advantageous to the taxpayer.  For instance, having incurred substantial losses in the trading activity following April 15 would seem to be just such a changed fact that made the election especially advantageous to the taxpayer. 

As the ruling describes:

To make a timely § 475(f)(1) election for Year 2, Taxpayers had to make the § 475(f)(1) election by the unextended due date of their tax return for Year 1. Taxpayers did not file their request for relief under § 301.9100-3 until Date 1. The late filing provided Taxpayers the benefit of e months of hindsight. During that time, Husband continued to trade in options. Taxpayers gained advantage from that hindsight because Taxpayers were able to determine the effect of a § 475(f)(1) election with knowledge that Husband’s ongoing options trading (a) produced additional losses of approximately $c, and (b) did not produce meaningful gain to absorb capital losses from Taxpayers’ claimed loss of $b from their investment in Partnership. Taxpayers have failed to provide strong proof that specific facts have not changed since the due date for making the election that make the election advantageous to Taxpayers. Accordingly, under § 301.9100-3(b)(3), Taxpayers are deemed to have not acted reasonably and in good faith.

The PLR also finds that granting the election would prejudice the interests of the Government.  The ruling notes that Reg. §301.9100-3(c)(2)(ii) provides:

(2) Special rules for accounting method regulatory elections.

The interests of the Government are deemed to be prejudiced except in unusual and compelling circumstances if the accounting method regulatory election for which relief is requested --

…

(ii) Requires an adjustment under section 481(a) (or would require an adjustment under section 481(a) if the taxpayer changed to the method of accounting for which relief is requested in a taxable year subsequent to the taxable year the election should have been made);

The taxpayer argued that this provision was not applicable to them since there was no need for a §481(a) adjustment in their case since they had disposed of all of their securities prior to the year end.  But the IRS argued that a zero §481(a) adjustment still represents a required adjustment:

Section 4 of Rev. Proc. 99-17 states that the election under section 475(f) determines the method of accounting an electing trader is required to use for federal income tax purposes for securities subject to the election. Because the election is integrally related to the change in accounting method to use the mark-to-market method of accounting under § 475, it is an accounting method regulatory election subject to § 301.9100-3(c)(2). Further, a § 475(f)(1) election requires a change in method of accounting that requires a § 481(a) adjustment. The change is not permitted to be implemented on a cut-off method.3

Since a § 475(f)(1) election is an accounting method regulatory election to which § 481(a) applies, the interests of the Government are deemed to be prejudiced given that Taxpayers have failed to present unusual and compelling circumstances to justify granting the requested relief.

[1] Revenue Ruling 99-17, Section 5.03

[2] PLR 202009013, February 27, 2020, https://www.irs.gov/pub/irs-wd/202009013.pdf (retrieved March 6, 2020)