Traders need to be aware of their
responsibilities under the law to maintain adequate books and records and
document their activities.
"But I have a friend who says (or my accountant says) that this is "too
conservative" and there's no reason for keeping all these records, it's a
waste of time!" What these people are invoking, whether they are aware of
it or not, is the "Cohan rule" [Cohan v. Comr., 39 F.2d 540 (2d Cir. 1930)]
. The Cohan rule allows a taxpayer to approximate the amount at issue
despite inadequate records, if it is clear that an expenditure was
An example of this might be - you have solid documentation that 50% of your
car mileage is valid business mileage, but you lost all off your gasoline
purchase receipts in a fire. The gasoline purchased can be approximated
based on the documented miles, the average MPG of your vehicle and the
average cost of gasoline at the pump.
As such, the Cohan rule lowers the requirements for substantiation of valid
business expenses if the IRS finds the taxpayer to be credible. If,
after considering the taxpayer's other records and everything else, the IRS
does not feel comfortable with the credibility of the taxpayer - then the
deductions are disallowed. Why take the chance? Laziness on the part of a
taxpayer? Because a tax preparer can earn twice as much by fluffing off the
work of documenting substantiation, so he can bill full price for doing two
client's tax returns in the time it otherwise might take for doing one?
The danger here is that when it comes to an Individual's Trader Status
and Trader Status Entities, the lack of credible substantiation can
lead to a revocation of Trader Status in its entirety and thus reverting the
taxpayer to Investor Status [Higgins v. Comr., 312 U.S. 212 (1941)]. When
doing this, the Cohan rule is not helpful. True, without substantiation the
deductions may still be allowed under the Cohan rule, but only as an
- treat your trading business
professionally and apart from your personal activities.
- avoid commingling business and
non-business assets and activities.
- save all invoices for expenses and
equipment for several years.
- also save all canceled checks,
bank statements, credit card statements and loan paperwork to support
payment of invoices.
- reconcile your broker's 1099-B
sales to your records.
- reconcile your annual net gain or
loss to your 12 monthly brokerage statements.
- verify that your downloaded
trading records are correctly based on transaction date as required for
IRS, and not by settlement date as per the SEC rules (usually just the
activity between December 25 and January 7 needs to be reviewed).
- keep copy of any form 2848 power
of attorney and show it to IRS if the need arises.
- never speak with the IRS about
your tax return or your trading activity, refer them to your CPA.
- avoid using any busch league "net
change in broker account value" as your primary method of computing
net gains or losses for the year. we've seen as many errors with traders
erroneously overpaying their taxes as illegally underpaying their taxes
using this foolhardy, unprofessional approach.
- preferably format your activity
like a schedule D: description, date acquired, date of sale, amount of
sale, tax basis or cost, net gain or loss. Many brokers do this for you,
others provide a download file to import into Excel or other software
All M2M Traders:
- keep copy of your mark-to-market
election and proof of timely filing.
- keep copy of your form 3115 for a
change to mark-to-market accounting and proof of timely filing.
- keep records clearly documenting
your year-end mark-to-market computations and your following year
adjustments to tax basis.
- verify that any year-end unsettled
transactions are properly accounted for (usually just the activity between
December 25 and January 7 needs to be reviewed).
Corporations and Multi Member LLCs:
- keep copy of form SS-4 and the IRS
acknowledgement of your federal identification number.
- keep copy of form 2553 and the IRS
acknowledgement of your s-corp election.
- issue stock certificates or member
certificates to shareholders/members and assure that they are "fully paid
for," preferably with a separate payment made by check from the
shareholder/member to the entity.
- maintain a minute book to document
what happened at annual meetings and special meetings.
- maintain an LLC operating
- maintain an owners' buy-sell
agreement funded with disability insurance or life insurance, as desired.
- establish your retirement plan
before December 31st.
- fund your retirement plan before
the initial due date of your tax return or...
- if you will absolutely be filing
timely, fund your retirement plan before the extended due date of your
A Recommended Chart of Accounts:
Earned Income is required for Retirement Plans
and Medical Insurance Plans:
Employee or "self-employed"
What Tax Records to Keep and For How Long:
- Income Tax Returns and Related
Items: Keep all federal and state income tax returns and supporting
documents (i.e., those items confirming your income and/or deductions) for
a minimum of three years after the return's filing date. The more prudent
route is to keep these returns and documents for six years. Why? The IRS
can assess additional taxes within three years of its filing date, but has
up to six years in which to make a tax assessment if the IRS determines
that a substantial amount of income has been omitted from the return.
- Property Taxes: The Statute
Of Limitations on personal property taxes are fifteen (15) years of more
after the due date of the tax. The sale of long-ago forgotten tax leins
on personal property you no longer own, or real property you still own can
come back to haunt you a decade later unless you have canceled checks and
stamp receipted tax bills to prove that you already paid.
- Mailing Receipts: Keep with
your file copy of each tax return the U.S. Postal Service receipt -- i.e.,
the registered mail receipt --showing the date the return was mailed. If
your return is filed electronically, keep a copy of the electronic filing
confirmation with a printed copy of the return. In the event the return is
misplaced or lost, this documentation will save you from penalties.
- Residential Property Records:
Keep settlement records from all of your home purchases and sales in a
safe place. This will help you determine basis for any future sale and
gain determination. In addition, keep records of the amounts that you
spend for home improvements with this file. These records will provide
documentation of your basis in the house if and when it comes time to
compute your taxable gain.
- Stock and Bond Records:
Keep records of your investment and trading purchases (e.g., stocks,
options, futures, mutual funds, and bonds). Besides providing you with a
date for determining the type of gain -- long term versus short term --
these records establish your basis in the investment and help to compute
the gain/loss when you sell. In addition, keep records that show a return
of capital on your investments.
- Depreciation Records: For
any rental real estate or depreciable business property that you own, keep
records of the property's cost, the purchase date, the method used to
calculate depreciation, and a schedule of all depreciation claimed on the
property in previous years. Maintain these records until you sell or
dispose of the property. Once you sell the property, keep these records
with the tax return on which you report the sale.
- Personal Records: Keep a
permanent file of personal records -- such as divorce agreements, copies
of estate and gift tax returns under which you received property, etc. - -
since they can provide a basis for determining your tax liability when you
dispose of the property.
- Other Records: There are
other situations in which you will benefit from keeping records. For
example, if you have made nondeductible contributions to an IRA or Roth
IRA, maintaining records of these contributions will facilitate proving
your tax liability when funds are withdrawn from the IRA.