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What is the Tax Significance of Distinguishing Between a Dealer, Trader, or Investor in Virtual Currency?

Author: Nicholas C. Mowbray, tax attorney at the law firm of BakerHostetler1

This communication does not constitute legal advice or an opinion of BakerHostetler. The views expressed in this  article are those of the author. 

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A taxpayer who purchases and sells investments is classified for tax purposes as an investor, trader, or dealer.2 Distinctions between the three are significant, and a classification as  one over the other may lead to substantially different federal income tax consequences.  

Investors and Traders  

The definition of an investor generally is a taxpayer that seeks to profit from changes in  the market price of their holdings, that is, those who attempt to buy low and sell high. Investors  anticipate earning a profit from increases in the market value of their long positions and  decreases in the market value of their short positions. A trader, in contrast, is generally defined  as a taxpayer that seeks to earn a speculative return based on market fluctuations and short-term  changes. While both investors and traders act on their own behalves, the key distinction is that a  trader is engaged in a trade or business of buying and selling investments, while an investor is  passively accumulating earnings by overseeing their investments and is not engaged in a trade or  business.  

For taxpayers, the distinctions between an investor and a trader are significant. This is  because a trader may deduct its business expenses, while an investor may be limited or unable to  deduct its expenses.3 Such expenses include, but are not limited to, investment management  fees, brokerage fees, interest expense (subject to a separate limitation), and state and local  income taxes.4

Unfortunately, there is no bright line test with respect to what constitutes a trader or  investor, and the dedication of time and effort to trading activity alone will not be determinative.  Instead, it is a question of fact, with the following factors being relevant:  

  • The nature of the income derived by the taxpayer, with items such as short-term gain and  loss indicating the taxpayer is a trader, while items such as long-term capital gain and  loss indicating the taxpayer is an investor;  
  • The frequency, extent, and regularity of the taxpayer’s trading activity. Factors include  whether trades are executed on a daily basis, whether there are gap periods between  trades, and the trading volume and rate of turnover of the taxpayer’s portfolio; and  
  • The average holding period of the investments.  

Dealers  

A taxpayer generally will qualify as a dealer if he or she buys and sells investments and  receives income through matching a buyer and seller of an investment by charging a fee. A  dealer generally purchases and holds assets as “inventory,” with the expectation of reselling the  investments at a profit not because of a rise in the investment’s value, but because the dealer has  or hopes to find a market of buyers who will purchase its inventory for a fee.  

One of the main distinctions between a trader and a dealer is that a dealer has customers,  while a trader does not. To conceptualize this, an example of a dealer in virtual currency is an  intermediary that simultaneously converts its customer’s virtual currency into fiat currency,  converts its customer’s fiat currency into virtual currency, and swaps its customer’s virtual  currency into another virtual currency.  

Similar to traders, a dealer will be considered to be engaged in a trade or business and  have the ability to deduct its businesses expenses. Differences exist between a trader and dealer  however, including the following:  

∙ A dealer generally earns ordinary income or loss while a trader generally earns short-term  capital gain or loss;  

∙ A dealer in securities generally is required to adopt a mark-to-market method of  accounting, while dealers in commodities and traders in commodities or securities  generally may elect a mark-to-market method of accounting; and  

o In general, this method requires the taxpayer to take into income as a gain or loss  the amount that would otherwise be recognized if the security or commodity were  sold for its fair market value on the last business day of the taxable year, with any  gain or loss treated as ordinary income.  

o A mark-to-market method allows a taxpayer to avoid certain limitations on the  deductibility of capital losses. Such an election, however, first requires  

establishing a (tax) position that virtual currency is a commodity or security.  While the IRS has not issued guidance on this, positions and arguments exist that  a virtual currency is a commodity for tax purposes.  

∙ Non-U.S. taxpayers may qualify for certain exemptions from having a taxable presence in  the United States as a result of the trading of securities and commodities (as the tax law  defines these terms). These exemptions are limited, however, if a non-U.S. taxpayer is a  dealer. The same point above regarding establishing a position that a virtual currency is a  commodity or security is also relevant to these exemptions.  

Takeaways  

Additional items that taxpayers should note about these distinctions are the following:  

  • Whether a taxpayer is an investor, trader, or dealer is a year-to-year determination and is  therefore something a taxpayer must analyze on an annual basis; and 
  • If a U.S. taxpayer holds an interest in a fund that distributes a Schedule K-1 to the  taxpayer, whether the activity reported on the Schedule K-1 constitutes investing, trading,  or dealing, is made at the fund level.  
  • In closing, taxpayers that are investors, dealers, and traders should consider the following:  ∙ Determining whether they qualify as an investor or trader;  
  • If a taxpayer is a non-U.S. trader, considering whether their investment activity is exempt  from U.S. taxation; and  
  • If a taxpayer is a trader or dealer, considering whether there is a benefit to a mark-to market election and if so, whether they are eligible. 

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1 © Baker & Hostetler LLP. Nicholas C. Mowbray is a tax attorney at the law firm of BakerHostetler. This  communication may be considered advertising under the rules regulating the legal profession. 

2https://www.irs.gov/taxtopics/tc429  

3https://www.irs.gov/businesses/small-businesses-self-employed/deducting-business-expenses 

4 Pre-2018, an investor could deduct investment expenses with certain limitations. The tax law changes in late-2017  however changed these

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