Category: Individuals
Subject: Self-Employment Tax
Title: Commodities Traders and Dealers, Traders, Investors in Securities
IRC Sections: 1401 through 1403, 1256
Filename: 1284.html
Date Produced: 10/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer, TP, is a partner in a partnership engaged in the business of trading commodities contracts. TP's K-1 from the partnership reflects income from Section 1256 transactions and a trade or business loss attributable to TP's share of the business expenses of the partnership. Income from Section 1256 transactions is treated as 60% long-term capital gain and 40% short-term capital gain. TP is registered with the Chicago Board of Trade; which in turn is designated as a contract market by the Commodities Futures Trading Commission.

Issue
Are the income and expense items flowing through to TP from the partnership subject to self-employment taxes?

Answer
The income and expense items set forth above are subject to self-employment tax.

Discussion
A taxpayer's securities activity can be broadly characterized for tax purposes in one of three different ways, with each characterization having its own distinct set of significant tax ramifications.

A securities dealer is a taxpayer engaged in the trade or business of selling securities. Such a person maintains an inventory of securities for sale to customers and earns a living primarily from the markup on such sales. Because a dealer holds securities for sale to customers in the ordinary course of business, such securities are not considered capital assets; accordingly, the gain or loss therefrom is ordinary gain or loss, not capital.

Since the dealer is engaged in a trade or business, the related business expenses are deductible above the line. Also, any interest expense incurred to carry securities is not subject to the investment interest limitation.

A securities trader is a taxpayer whose securities activities rise to the level of a trade or business but such a taxpayer does not maintain an inventory of securities for sale to customers. A securities trader tends to earn a living from price fluctuations in the securities held. Since securities in this context are not held for sale to customers in the ordinary course of business, the trader can derive capital gains and losses from trading activities. Again, since there is a trade or business, related business expenses are deductible above the line. Also, any interest expense incurred to carry securities is not subject to the investment interest limitation.

The final category is that of investor, which is where most taxpayer's tend to fit. An investor is not engaged in a trade or business. Obviously, an investor does not maintain an inventory of securities; hence, gains and losses on securities transactions are typically capital. In the absence of a trade or business, the investor's expenses must be taken as other itemized deductions subject to the 2% floor, and any interest expense incurred to carry securities is subject to the investment interest limitations.

Ordinarily, the income from a unincorporated taxpayer's trade or business is subject to self-employment tax as provided for in Internal Revenue Code Sections 1401 through 1403. Various exclusions are provided, including an exclusion under Section 1402(a)(3)(A) for capital gains, whether short-term or long-term. In addition, although the income from interest or dividends is ordinarily exempt from self-employment tax under Section 1402(a)(2), such income earned by a securities dealer is subject to self-employment tax by virtue of the last sentence thereof.

Clearly, investors are not subject to self-employment tax because their activities do not rise to the level of a trade or business, a threshold requirement for imposition of self-employment tax. Clearly, dealers are subject to self-employment tax on all their income: a trade or business exists, and all income or loss is ordinary. Also, as just stated, even the interest and dividend income of a dealer is subjected to self-employment tax.

This leaves only the category of traders who are in the peculiar position of being engaged in a trade or business the income from which typically consists largely of capital gains. Since Section 1402(a)(3)(A) excludes capital gains from self-employment tax, it seems that a special self-employment tax exclusion is available to such taxpayers.

Finally, there is also a special self-employment tax category for taxpayers dealing in Section 1256 contracts. Since Section 1256 contracts produce both short-term and long-term capital gains, such taxpayer's income would, absent a special rule, be exempt from self-employment tax just like the securities trader described above.

Section 1402(i) provides a special rule for so-called dealers in Section 1256 contracts. Under this special rule, the income from Section 1256 contracts is subject to self-employment tax notwithstanding its status as capital gain. Given the backdrop of the characterization of some taxpayers as dealers and others as traders, the terminology "commodities dealer" is initially troublesome. Is it possible to be a commodities trader rather than a commodities dealer and thereby avoid this special rule?

Section 1402(i)(2)(B) resolves the issue by defining a commodities dealer for purposes of Section 1402(i) as a person who regularly engages in trading Section 1256 contracts and is registered with a domestic board of trade which is designated as a contract market by the Commodities Futures Trading Commission.

As I understand it, TP is regularly engages in trading Section 1256 contracts and is registered with a board of trade which appears to meet the exact specification set forth in the statute. Accordingly, it seems clear that pursuant to Section 1402(i), TP's income and loss flowing from the partnership would be subject to self-employment tax.