Trading is a business. You are engaged in a for-profit endeavor, providing liquidity to the markets and extracting your fair share for your efforts. Setting up your trading as a business is paramount and the cornerstone of your effort and the heart of my book The Business of Trading.
I regularly review US Tax Court rulings from trader cases for any relevant changes and they are tallied here. Today I review the mistakes a trader made in calculating allowed expenses inside his trading business.
Background: Taxpayer petitioned for redetermination of income-tax deficiency arising from disallowance of itemized and business-expense deductions.
Holdings: The Tax Court held that:
- Trader taxpayer was not entitled to business-expense deduction for cost of utilities for his home;
- Trader taxpayer was not entitled to business-expense deduction for cost of supplies;
- Trader taxpayer was not entitled to business-expense deduction for cost of legal services; and
- Trader taxpayer was not entitled to business-expense deduction for cost of educational expenses.
Decision for IRS.
Rehman v. Comm’r, 105 T.C.M. (CCH) 1448 (T.C. 2013)
The trader Rehman above did establish a trading business. He then correctly deducted his trading profits by the expenses listed above in 1-4. The IRS said wait a minute, those deductions are allowable inside a business, but only if you comply with the rules for recording them. Here are Rehman’s mistakes.
- Cost for Utilities-“Rehman claimed a deduction for the cost of utilities in his home, a one-bedroom apartment. He testified that he used the living room-one room out of the three rooms in his apartment-exclusively for business purposes. But Rehman supplied no information about the layout of his apartment that could make this assertion seem credible, and he was not a credible witness. We need not accept his unsupported testimony. See Tokarski v. Commissioner, 87 T.C. at 77. Since he has not shown that he used any portion of his home exclusively for business, Rehman may not deduct any portion of his utilities expenses.”
Solution– Rather than calculating what portion of your home is for business and creating a layout, take a general home office deduction for your trading business.
- Cost of Supplies– “To support his claim for a deduction for supplies, Rehman introduced a list of expenses that showed: (1) the date, (2) a description, and (3) the amount he spent on various purchases. However, the list does not show that the expenses were related to Rehman’s business as a securities trader. Rehman did not testify that the expenses were related to his business. Without further evidence of the relationship to his business, Rehman has failed to satisfy his burden of proving he is entitled to deduct the $3,763 at issue for supplies.”
Solution– A taxpayer may deduct the cost of supplies if the cost is an ordinary and necessary expense directly connected with the taxpayer’s business. Sec. 162(a); sec. 1.162–1(a), Income Tax Regs. Simply documenting office supplies(E.g. ink for your copiers) and their relationship to your trading business is all it takes. No brainer.
- Cost of Legal Services– “Rehman asserts that he also made a cash payment to a lawyer who he can no longer contact or find. He has introduced no receipt, invoice, or bill, and he did not explain what the payment was for.”
Solution– A taxpayer may deduct the costs of legal and professional services if the costs are ordinary and necessary and directly connected with the taxpayer’s business. See sec. 162; Levenson & Klein, Inc. v. Commissioner, 67 T.C. 694, 719–721, 1977 WL 3679 (1977) (legal services); sec. 1.162–1, Income Tax Regs. Simple documentation with a receipt from the lawyer would be sufficient.
The trader in this case did do some things right. “During 2007 Rehman paid an organization called the Online Trading Academy for training related to his securities-trading business. The $4,090 the IRS allowed as a deduction for educational expenses is for the cost of this training.” The trader had a receipt for this expense. Outside of a trading business a retail trader cannot deduct such an expense and simply eats the expense rather than using it as a deduction against his trading profits, thus lowering his taxable income.
However the follies continued.
- Costs of Educational Expenses- “The IRS has conceded that Rehman is entitled to $4,090 of the $9,990 deduction he claimed for educational expenses. Thus, the amount in dispute is $5,900. Rehman’s deduction relates to his alleged purchase of three sets of compact discs and digital video discs entitled, respectively: “Ultimate Professional Trader Plus CD Library”, “Professional Trader CD/DVD Set Days One Through Three”, and “Professional Trader CD/DVD Set Days Four Through Seven”. Rehman possessed these discs at trial. However, his testimony about the purchase price of the discs was vague, unclear, internally inconsistent, and unsupported by any corroborating receipts or other documentary evidence. We are not persuaded that Rehman spent $5,900 on educational expenses beyond the $4,090 the IRS conceded.”
Solution– Get and keep a receipt for any purchase over $75! All business owners do this.
We can learn from other business traders’ tax mistakes. Get your trading business set up correctly from the start and keep as much of the hard-earned trading profits you can.
Enuf said.