T.C. Memo. 2011-159
UNITED STATES TAX COURT
RICHARD KAY, JR., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 18203-09. Filed July 6, 2011.
Richard Kay, Jr., pro se.
Mindy S. Meigs, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined deficiencies and
penalties as follows:
Penalty
Year Deficiency Sec. 6662(a)
2001 $131,693 $26,338.60
2002 90,020 18,004.00
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The issues for decision are: (1) Whether petitioner was a trader
in securities during 2000, 2001, and 2002; (2) whether petitioner
is entitled to claim a net operating loss (NOL) carryover from
2000 in 2001 and 2002; (3) whether petitioner must include a
State income tax refund in his taxable income in 2002; and (4)
whether petitioner is liable for the penalties under section
6662. Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code) in effect for the years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference. At the
time the petition was filed, petitioner resided in California.
Petitioner holds a degree in economics from San Diego State
University. During the years in issue, petitioner operated a
ball bearing manufacturing and distribution business, Clean Wave
Management, Inc. (Clean Wave), an S corporation. Petitioner has
been Clean Wave’s sole shareholder, officer, and director from
the date of its incorporation in 1995 to the present. During the
relevant period, petitioner resided in one unit of a duplex, with
Clean Wave operating out of the other unit. Clean Wave had three
additional employees who worked with petitioner throughout the
years in issue.
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On his 2000-2002 Forms 1040, U.S. Individual Income Tax
Return, as amended, petitioner reported wages paid by Clean Wave
of $36,400, $43,600, and $52,000 respectively. On Clean Wave’s
2000-2002 Forms 1120S, U.S. Income Tax Return for an S
Corporation, as amended, the corporation reported net income of
$657,683, $385,270, and $278,213.
Petitioner traded securities prior to and throughout 1999-
2002. Petitioner made a mark-to-market election under section
475(f) in 1999 and did not revoke that election through 2002.
The number of days petitioner traded securities and the
number of transactions he engaged in from 2000-2002 was as
follows:
2000 2001 2002
Trading Activity Trading Activity Trading Activity
Trading No. of Trading No. of Trading No. of
Days Trans. Days Trans. Days Trans.
Jan. 4 11 0 0 1 4
Feb. 9 50 1 2 2 8
Mar. 7 17 0 0 5 14
Apr. 8 62 0 0 2 14
May 3 15 0 0 2 7
June1 1 4 0 0 3 5
July 7 38 1 1 6 32
Aug. 6 24 0 0 0 0
Sept. 3 14 2 16 0 0
Oct. 6 13 6 28 0 0
Nov. 11 32 3 5 0 0
Dec. 8 33 5 20 0 0
Total 73 313 18 72 21 84
1
The record does not include complete information for June
2000. The totals include the data that is available in the
record. On the basis of what the record does provide, the
missing data would not have significantly changed the number of
days petitioner traded securities or the number of transactions
he completed.
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There were 252 total trading days in 2000 and 2002, and 248
trading days in 2001.
In 2000, the total value of the securities petitioner
purchased was over $20 million, and the total value of the
securities petitioner sold was also over $20 million. Petitioner
bought and sold the same stock on the same day on only six
occasions in 2000. In 2001, the total value of the securities
purchased and sold was $2,349,320.35 and $1,576,548.02
respectively. He bought and sold the same stock on the same day
on only four occasions in 2001. In 2002, the total value of the
securities purchased and sold was $1,234,427.90 and $1,852,167.29
respectively. He bought and sold the same stock on the same day
on only three occasions in 2002.
Petitioner attached a Schedule C, Profit or Loss From
Business, to his 2000 Form 1040 where he reported his income,
losses, and expenses from his sales of securities. On that form
he listed his principal business or profession as “DAY TRADE”.
On his 2000 Schedule C, petitioner reported a net loss of
$2,052,637, arising from $1,960,060 in losses from sales of
stocks and $92,577 in expenses. Petitioner offset other ordinary
taxable income by deducting some of these losses.
On his amended 2001 Schedule C, petitioner reported a net
loss of $399,740, arising from $399,162 in losses from the sale
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of stocks and $578 in expenses. He also reported an NOL of
$1,396,943 carried over from 2000.
On his 2002 Schedule C, petitioner reported a net loss of
$278,297, arising from $262,921 in losses from the sale of stocks
and $15,376 in expenses. On his 2002 return, he also reported
the same $1,396,943 NOL carried over from 2000, some of which he
used to offset other ordinary income.
Petitioner claimed a deduction of $21,806 for State and
local income taxes on his 2001 return. At the time he filed his
return he reported a negative income and thus did not receive a
tax benefit from the deduction. However, in the notice of
deficiency, the IRS disallowed the ordinary losses for 2001 as
described above. Consequently, the notice of deficiency included
an additional $16,059 of income in 2002 after the IRS became
aware that during 2002 petitioner had received a refund of that
amount from his State taxes.
OPINION
Trading Activities
Respondent disallowed deductions for ordinary losses beyond
the limit of $3,000 under section 1211(b) for losses arising from
petitioner’s trading of securities during 2001 and 2002. See
sec. 165(f). Respondent also disallowed deductions for an NOL
carried over from 2000 to the years in issue arising from similar
trading activity. We may determine the correct amount of taxable
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income or NOL for a year not in issue (whether or not the
assessment of a deficiency for that year is barred) as a
preliminary step in determining the correct amount of an NOL
carryover to a taxable year in issue. Lone Manor Farms, Inc. v.
Commissioner, 61 T.C. 436, 440 (1974), affd. without published
opinion 510 F.2d 970 (3d Cir. 1975).
In general, for Federal tax purposes, a person who purchases
and sells securities falls into one of three distinct categories:
dealer, trader, or investor. See King v. Commissioner, 89 T.C.
445, 458-459 (1987). The parties have not argued that petitioner
was a dealer for the years in issue.
Section 475(f) provides generally that a taxpayer engaged in
business as a securities trader may elect to use the
mark-to-market method of accounting for securities held in a
business. Under the mark-to-market method of accounting a
taxpayer generally recognizes at the end of the year ordinary
gain or loss on all securities held in the business as if the
securities were sold at the end of the year for fair market
value. Sec. 475(d)(3), (f)(1)(A)(i); Lehrer v. Commissioner,
T.C. Memo. 2005-167, affd. 279 Fed. Appx. 549 (9th Cir. 2008).
Ordinary losses are thereby made available to offset ordinary
income and are not subject to the $3,000 limitation, as relevant
here, imposed by section 1211(b) on the deduction of capital
losses in excess of capital gains. See Vines v. Commissioner,
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126 T.C. 279, 288 (2006). Petitioner made a timely
mark-to-market election pursuant to section 475(f). However,
section 475(f) applies only to those engaged in a trade or
business as traders in securities.
Traders are engaged in the trade or business of selling
securities for their own account. See King v. Commissioner,
supra at 457-458. Investors likewise buy and sell for their own
account, but they are not considered to be in the trade or
business of selling securities. See Arberg v. Commissioner, T.C.
Memo. 2007-244. Unlike an investor, a trader’s expenses are
deducted in determining adjusted gross income rather than as
itemized expenses. Whether petitioner’s activities constituted a
trade or business is a question of fact. See Higgins v.
Commissioner, 312 U.S. 212, 217 (1941); Cameron v. Commissioner,
T.C. Memo. 2007-260.
In determining whether a taxpayer is a trader, nonexclusive
factors to consider are: (1) The taxpayer’s intent, (2) the
nature of the income to be derived from the activity, and (3) the
frequency, extent, and regularity of the taxpayer’s securities
transactions. Purvis v. Commissioner, 530 F.2d 1332, 1334 (9th
Cir. 1976), affg. T.C. Memo. 1974-164. For a taxpayer to be a
trader, the trading activity must be substantial, which means
“‘frequent, regular, and continuous enough to constitute a trade
or business’”. Ball v. Commissioner, T.C. Memo. 2000-245
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(quoting Hart v. Commissioner, T.C. Memo. 1997-11). A taxpayer’s
activities constitute a trade or business where both of the
following requirements are met: (1) The taxpayer's trading is
substantial, and (2) the taxpayer seeks to catch the swings in
the daily market movements and to profit from these short-term
changes rather than to profit from the long-term holding of
investments. King v. Commissioner, supra at 458-459; Mayer v.
Commissioner, T.C. Memo. 1994-209.
With respect to the first requirement, when evaluating
whether a taxpayer’s trading activities were substantial we have
considered the number of executed trades in a year and the amount
of money involved in those trades. When the number of trades
made and the amount of money involved in those trades is small in
a given year, a taxpayer’s trading activity is insubstantial.
See Moller v. United States, 721 F.2d 810, 813-814 (Fed. Cir.
1983) (finding 124 trades in one year and 106 trades in the
following year was insubstantial); Holsinger v. Commissioner,
T.C. Memo. 2008-191 (finding 289 trades with aggregate sales of
$754,277 in one year at issue was insubstantial). When the
number of trades and the amount of money involved in those trades
is large, a taxpayer’s trading activity is substantial. See
Mayer v. Commissioner, supra (1,100 sales and purchases with
gross receipts of more than $10 million in each year at issue was
substantial); Paoli v. Commissioner, T.C. Memo. 1991-351 (326
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sales of stocks with gross receipts of more than $9 million in
the year at issue was substantial).
We have also considered the amount of time petitioner spent
buying and selling securities. A taxpayer’s trading activity is
insubstantial when the taxpayer trades only for a small portion
of the trading days in the particular year. See Holsinger v.
Commissioner, supra (finding “it doubtful whether the trades were
conducted with the frequency, continuity, and regularity
indicative of a business” when trades occurred on approximately
40- to 45-percent of the trading days in the years at issue). In
addition, a taxpayer engaged in sufficiently substantial trading
activity to qualify as a trade or business will generally rely on
that activity as their sole or primary source of income. See
Chen v. Commissioner, T.C. Memo. 2004-132.
With respect to the second requirement for classification as
a trader, a taxpayer must have sought to profit from short-term
swings in the stock market. See Mayer v. Commissioner, supra.
Thus, investors generally hold securities for relatively long
periods of time while traders hold securities for short periods.
See Holsinger v. Commissioner, supra (holding that taxpayers did
not demonstrate that they sought to profit from short-term swings
in the market because they rarely bought and sold the same stock
on the same day and held a significant amount for more
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than 31 days); see also Estate of Yaeger, T.C. Memo. 1988-264,
affd. 889 F.2d 29 (2d Cir. 1989).
The number of trades petitioner engaged in during the years
2000, 2001, and 2002 was not substantial. In 2000, 2001, and
2002, petitioner executed 313 trades, 172 trades, and 84 trades
respectively. We found similar numbers of trades to be
insubstantial in the cases discussed above. In 2000, however,
the total amount of money involved in trading was substantial.
In that year, petitioner made over $20 million in purchases and a
similar amount in sales. In 2001 and 2002, petitioner’s gross
purchases and gross sales, which ranged between $1 million and
$2.5 million, were less substantial. In any case, managing a
large amount of money is not conclusive as to whether
petitioner’s trading activity amounted to a trade or business.
See Moller v. United States, supra at 814.
Petitioner’s trading activity was infrequent. In the years
2000, 2001, and 2002, petitioner conducted trading activity on
just 29 percent, 7 percent, and 8 percent of the possible trading
days in each year, respectively. Income from Clean Wave was his
primary source of income. Despite petitioner’s assertion that he
spent the majority of his time as a day trader, the number of
days he actually made trades show otherwise.
Petitioner generally did not hold stocks for intervals that
demonstrate an intention to profit from day trading. The
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majority of the stocks he purchased and sold in each of the years
at issue were held for over 30 days. Petitioner rarely purchased
and sold the same stock on the same day.
Overall, petitioner has not met the requirements for his
trading activity to be treated as a trade or a business. Thus he
is limited to a $3,000 deduction of losses arising from the
purchase and sale of securities in 2001 and 2002 under section
1211(b) and may not carry forward the NOL generated in 2000.
State Income Tax Refund
Petitioner bears the burden of proving that the
determination of unreported income in the notice of deficiency is
erroneous. See Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933).
Generally, under section 111 and the regulations thereunder,
if a tax was deducted on a prior year’s return that resulted in a
reduction of tax and a tax benefit to the taxpayer, the
taxpayer’s subsequent recovery of the tax must be included in
gross income in the year the recovery is received. Prewitt v.
Commissioner, T.C. Memo. 1995-24; Kadunc v. Commissioner, T.C.
Memo. 1992-61, affd. without published opinion 981 F.2d 1251 (4th
Cir. 1992).
Petitioner reported a deduction for State income taxes of
$21,806 on his 2001 tax return. Because we here determine that
his income in 2001 was not offset by the securities trading
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losses, he will receive a tax benefit from that deduction.
Petitioner did not address this issue in the petition or at trial
and did not submit any briefs. Accordingly, as respondent
determined in the notice of deficiency, the refund of State
income tax received in 2002 is includable in gross income for
that year.
Accuracy-Related Penalty
Section 6662(a) and (b)(1) and (2) imposes a 20-percent
accuracy-related penalty on any underpayment of Federal income
tax attributable to a taxpayer’s negligence or disregard of rules
or regulations or substantial understatement of income tax.
Section 6662(c) defines negligence as including any failure to
make a reasonable attempt to comply with the provisions of the
Code and defines disregard as any careless, reckless, or
intentional disregard. Disregard of rules or regulations is
careless if the taxpayer does not exercise reasonable diligence
to determine the correctness of a return position that is
contrary to the rule or regulation. Sec. 1.6662-3(b)(2), Income
Tax Regs. A substantial understatement of income tax exists if
the understatement exceeds the greater of 10 percent of the tax
required to be shown on the return or $5,000. Sec.
6662(d)(1)(A).
Under section 7491(c), the Commissioner bears the burden of
production with regard to penalties and must come forward with
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sufficient evidence indicating that it is appropriate to impose
penalties. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
However, once the Commissioner has met the burden of production,
the burden of proof remains with the taxpayer, including the
burden of proving that the penalties are inappropriate because of
reasonable cause or substantial authority. See Rule 142(a);
Higbee v. Commissioner, supra at 446-447. Considering the
erroneous nature of the deductions and the amounts of the
resulting underpayment of tax, respondent has satisfied the
burden of producing evidence that the penalty is appropriate for
2001 and 2002.
The accuracy-related penalty under section 6662(a) is not
imposed with respect to any portion of the underpayment as to
which the taxpayer acted with reasonable cause and in good faith.
Sec. 6664(c)(1); Higbee v. Commissioner, supra at 448. The
decision as to whether a taxpayer acted with reasonable cause and
in good faith is made on a case-by-case basis, taking into
account all of the pertinent facts and circumstances. See sec.
1.6664-4(b)(1), Income Tax Regs.
Petitioner does not separately address the penalty issue.
He failed to allege that the Commissioner’s imposition of a
penalty was erroneous in his petition, and the issue is therefore
deemed conceded. See Rule 34(b)(4); Swain v. Commissioner, 118
T.C. 358, 363-365 (2002). In any event, petitioner has not
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demonstrated reasonable cause. Petitioner is a sophisticated
investor, but his references to his accountant at trial were
insufficient to prove that he relied on professional advice or
otherwise sought to determine the appropriate tax treatment of
his transactions. Petitioner is liable for the penalty for 2001
and 2002.
We have considered the other arguments of the parties, and
they either are without merit or need not be addressed in view of
our resolution of the issues. For the reasons explained above,
Decision will be entered for
respondent.