A trader generally executes an extremely large number of trades during the year attempting to take advantage of very short-term variations in the prices of securities.  While some find this pursuit profitable, many find that their ability to harvest those short-term gains doesn’t exist, and while discovering this fact they encounter significant losses.  Unfortunately, by default these losses are capital losses, resulting in only being able to deduct $3,000 per year of such losses against other income—and all too often such traders have losses that are well in excess of such limits, running to five or six figure losses.

There is some relief available.  IRC §475(f)(1) provides in part:

(1) Traders in securities

(A) In general

In the case of a person who is engaged in a trade or business as a trader in securities and who elects to have this paragraph apply to such trade or business--

(i) such person shall recognize gain or loss on any security held in connection with such trade or business at the close of any taxable year as if such security were sold for its fair market value on the last business day of such taxable year, and

(ii) any gain or loss shall be taken into account for such taxable year.

Proper adjustment shall be made in the amount of any gain or loss subsequently realized for gain or loss taken into account under the preceding sentence.

With this election in place, the losses are no longer capital losses and can lead to a net operating loss for the year.

In Private Letter Ruling 202145015 a taxpayer is looking to make this election after encountering significant losses in the second year of his trading activity, after having shown income in the first year.

The time for making the election is set by the IRS pursuant to authority provided by IRC §7805(d).  Revenue Procedure 99-17 outlines how and when the election is to be made.  The PLR describes these provisions as follows:

Rev. Proc. 99-17, 1999-1 C.B. 503, sets forth the requirements for making an election under § 475(f). Under section 5.03 of that revenue procedure, a taxpayer must file an election statement not later than the due date (without regard to any extension) of the original federal income tax return for the taxable year immediately preceding the election year and must attach the statement either to that return or, if applicable, to a request for an extension of time to file that return. Section 5.04 of Rev. Proc. 99-17 sets forth the requirements for the statement. The statement must describe the election being made, the first taxable year for which the election is effective, and, in the case of an election under § 475(f), the trade or business for which the election is made. Section 4 of Rev. Proc. 99-17 provides that an election under § 475(f) determines the method of accounting that an electing taxpayer is required to use for federal income tax purposes for securities subject to the election. Once a valid election is made, the taxpayer is required to use a mark-to-market method of accounting under § 475. Section 4 of Rev. Proc. 99-17 also provides that if a taxpayer fails to change the taxpayer’s method of accounting to comply with the election, then the taxpayer is on an impermissible method.

Section 6.01 of Rev. Proc. 99-171 provides that a change in a taxpayer’s method of accounting is a change in method of accounting to which the provisions of § 446 and §481 and the regulations promulgated thereunder apply. Section 6.03 of Rev. Proc. 99-17 generally provides that if a taxpayer changes its method of accounting under section 6.01 of Rev. Proc. 99-17, the taxpayer must take into account the net amount of the § 481(a) adjustment over the applicable period.[1]

Obviously, the taxpayer did not timely make the election, but since the timing of the election is set by the IRS, not provided for in the statute, the IRS can grant relief for such late filing.  In this case, such a request would be made under Reg. §301.9100-1 and 3.  As the PLR notes, the regulations provide “[g]enerally, a taxpayer must provide sufficient evidence to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and that the grant of relief will not prejudice the interests of the Government.”[2]

The PLR goes on to describe the tests that will be applied under Reg. §301.9100-3:

Section 301.9100-3(b)(3) provides rules as to when a taxpayer is deemed to have not acted reasonably and in good faith. Section 301.9100-3(b)(3)(iii) provides that a taxpayer is deemed to have not acted reasonably and in good faith if specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer. In such a case, the Service will grant relief only when the taxpayer provides strong proof that the taxpayer's decision to seek relief did not involve hindsight.

Section 301.9100-3(c) provides that the Commissioner will grant a reasonable extension of time to make a regulatory election only when the interests of the Government will not be prejudiced by the granting of relief. Section 301.9100-3(c)(1)(i) provides that the interests of the Government are prejudiced if granting relief would result in a taxpayer having a lower tax liability in the aggregate for all taxable years affected by the election than the taxpayer would have had if the election had been timely made (taking into account the time value of money).

Section 301.9100-3(c)(2) provides special rules for accounting method regulatory elections. Section 301.9100-3(c)(2)(ii) provides that 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 requires an adjustment under § 481(a) (or would require an adjustment under § 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).[3]

A major problem with getting relief for this election is the fact that a taxpayer who follows the rules will have to make his/her election very early in the year where the treatment will first apply, while one making the election following the year end will automatically have the advantage of knowing the actual results for the year.  So a late electing taxpayer is, by the very nature of the election, gaining an advantage for having failed to follow the law if the IRS grants relief. Not unexpectedly, the IRS is very reluctant to grant relief for this late election.

In this case, the ruling explained the situation as follows:

In late Year 1, certain * * * were sold, which resulted in Husband recognizing gain under § 1231 of the Code. Husband used his share of the sales proceeds to fund two investment accounts. One account was held in Husband's name. The other account was held in the name of Partnership. Partnership was formed on Date 2. Partnership is a State limited liability corporation treated as a partnership for federal income tax purposes. Partnership uses a calendar year as its taxable year. Partnership is owned by Husband and Company. Taxpayer represents that pursuant to a partnership agreement all items attributable to Partnership's trading activities are allocated to Husband. Taxpayer represents that Husband became a day-trader in late Year 1. Taxpayer represents that Husband engaged in trading activity on behalf of Taxpayer, and through and on behalf of Partnership, from late Year 1 through Year 2.[4]

The taxpayer pleads that even though his election is late, he thought he’d get ordinary loss treatment and wasn’t aware of the need to make the election:

Taxpayer represents that Husband believed that gain or loss from the trading activities would be treated as ordinary gain or loss. Specifically, Taxpayer represents that Husband believed that losses from his trading activities in Year 2 could be carried back as ordinary losses to Year 1 to offset the § 1231 gains in Year 1. Taxpayer represents that Husband was unaware of the mark to market election under § 475(f). Taxpayer engaged the services of Law Firm in Date 3. Taxpayer represents, that at this time, Taxpayer became aware of the § 475(f) election requirement and of the procedure supporting a request to make a late § 475(f) election.[5]

The IRS rarely grants this relief and the IRS did not find that this was one of those highly unusual cases where relief is warranted.  First, the IRS notes that the agency did not find that the taxpayer presented evidence that he had acted reasonably and in good faith:

To make a timely § 475(f)(1) election for Year 1 or Year 2, Taxpayer had to make the § 475(f)(1) election by Date 4 for Year 1, or by Date 5 for Year 2. Date 4 and Date 5 are the respective due dates of Taxpayer’s federal income tax returns (without regard to extensions) for each taxable year immediately preceding Year 1 and Year 2.

Taxpayer’s request for relief under § 301.9100-3 was not made until Date 1. Taxpayer’s request for a late filing of the § 475(f)(1) election was made with the benefit of y months of hindsight for Year 1, and z months for Year 2. Husband continued to trade during late Year 1 and Year 2. Taxpayer gained a benefit from hindsight because Taxpayer was able to determine the effect of a § 475(f)(1) election with the benefit of knowing Husband’s trading results for Year 1 and Year 2. Moreover, Taxpayer failed to provide strong proof showing that its decision to seek relief to make a late election did not involve hindsight. Accordingly, under § 301.9100-3(b)(3), Taxpayer is deemed to have not acted reasonably and in good faith.[6]

The ruling also finds that the interests of the Government would be prejudiced if the relief was granted:

Under § 301.9100-3(c)(2)(ii), 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 requires an adjustment under § 481(a) (or would require an adjustment under § 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). Taxpayer has not presented unusual and compelling circumstances for its failure to timely make a § 475(f)(1) election.

Since a § 475(f)(1) election is an accounting method regulatory election that requires a § 481(a) adjustment, the interests of the Government are deemed to be prejudiced because Taxpayer has failed to present unusual and compelling circumstances to justify granting the requested relief.[7]

Thus, the IRS denied relief to the taxpayer.

For those who have followed the IRS rulings in this area, that result is not surprising—in fact, the very rare IRS ruling granting relief is what is found truly shocking.  But we are shocked very, very rarely in this area.

[1] PLR 202145015, November 12, 2021, https://www.taxnotes.com/research/federal/irs-private-rulings/letter-rulings-%26-technical-advice/taxpayer-can%e2%80%99t-make-late-mark-to-market-election/7clk2?h=202145015

[2] PLR 202145015, November 12, 2021

[3] PLR 202145015, November 12, 2021

[4] PLR 202145015, November 12, 2021

[5] PLR 202145015, November 12, 2021

[6] PLR 202145015, November 12, 2021

[7] PLR 202145015, November 12, 2021