Australian Taxation - How Long Should Business Records Be Retained?

A case that was recently decided in the Federal Court highlights a problem in relation to the keeping of business records. During the 1988 income year, a unit trust engaged in the purchase of a significant investment. It was not a good investment. Not too long afterwards the investment was worthless and in May 1993 the investment was sold for $1. This resulted in the unit trust incurring a capital loss of nearly $2.5m.

All of the units in the trust were sold from the original owner to a new owner in two tranches. One was in June 1993 and the other was in June 1995.

Capital losses may only be deducted for tax purposes against capital gains. Put another way, capital losses may not be used as a deduction against normal income. Due to this, the capital losses were carried forward by the unit trust until a capital gain was made by the unit trust in 2001.

The Australia Taxation Office ("ATO") raised amended assessments against the ultimate beneficiaries of the trust and would not allow the capital loss of $2.5m to be set off against the capital gain made in 2001. The beneficiaries objected to this and the matter found its way to the Federal Court.

The main argument of the ATO was that the trust had fundamentally changed through some things that happened in 1993. I won't go into the details of that.

However, the ATO also argued that the taxpayers could not prove that the purchase of the investment occurred in 1988 because, among other things, the primary documents that evidence the transaction no longer existed. This was so even though the financial statements of the unit trust showed the acquisition and there was verbal evidence from the people who actually engaged in the transaction. I note that the financial statements were prepared by a reputable firm of Chartered Accountants.

In his testimony before the court, the original owner of the units said that he did not have any of the business records of any of his companies or entities from 21 years ago. I know of few people that would.

So here's the point. Generally, businesses are required to keep their records for a five year period under the Australian taxation law. But when it comes to capital gains tax, you need to keep records of everything that may be relevant to working out whether you have made a capital gain or capital loss. And, according to the ATO publication "Record Keeping For Small Business", "You must keep these records for five years after you sell or otherwise dispose of an asset...". So, you may need to keep the records for a very long time.

You will note in the case I refer to above that the ATO required the taxpayer to produce business records of a transaction that was 21 years old. Further, the disposal of the investment occurred in 1993, so that was 16 years earlier (not five).

The moral of the story is this: if you think that a transaction may have long term significant tax implications, don't (ever?) throw out the primary documents that relate to that transaction. Keeping an electronic (scanned) image is something that you should consider.

Wishing you easier business.

John M. Jeffreys

Taxation of Professional Stock Traders

The tax rules for stock investors in general requires three steps. Step one is the netting of short-term capital gains and short-term capital losses. Step two is the netting of long-term capital gains and long-term capital losses. Step three is the netting of net short term gains/losses and net long-term gains/losses. Any capital losses in excess of $3,000 are carried forward indefinitely to offset future capital gains plus $3,000 of ordinary income every year, until the capital losses are used up. But what if you are a "day trader"? What special tax rules exist for day traders? This article will address those unique tax rules that apply to day traders.

What is a day trader? In general, a day trader, is anyone who engages in the business of trading stock. You are in the business of trading stock, and thus not an ordinary stock investor, when the frequency of your trading activity is such that it meets the "material participation" test. Qualifying as a trader under this material participation test is difficult because one must be active in the securities markets on a daily basis and attempt to profit from short-term swings in security prices. Many online investors fail this test, but some day traders (most of whom are also online investors) meet the standard. InPurvis [37 AFTR2d 76-968, 530 F2d 1332 (1976, CA-9)], the Ninth Circuit Court of Appeals upheld a prior tax court decision [Purvis, TC Memo 1974-164 (1974)] and agreed with the Tax Court that in order to be classified as trading, the activity should be performed with sufficient frequency to "catch the swings in the daily market movements and profit thereby on a short-term basis." Day traders can take a buy-and-hold approach, but most of them seek to take advantage of short-term market fluctuations and this short-term market fluctuation criteria is the linchpin in qualifying some day traders as traders rather than investors for federal income tax purposes.

What's so important about being considered a trader verses an investor?
Investor losses in excess of $3,000 a year are not deductible in the year of the loss. This excess loss amount must be carried forward. There is no time limit on the future utilization of the excess losses, but if you continue to rack up losses each year, you will be limited, each year, to this $3,000 loss limitation. Traders, on the other hand, are not limited to this $3,000 annual loss limitation. They are able to deduct their entire net loss for the year on their individual income tax return. Traders report their net gains/losses on Form 4797 as ordinary income (investors report their net gains/losses on Schedule D. Net long-term capital gains are taxed at the favorable long-term capital gains tax rates (currently 15%). Traders are also eligible for certain deductions that are not available to investors. One such deduction is the home office deduction. Traders may use their net income from trading activities to fund a SEP-IRA, and thus further reduce their taxable income. Another such deduction available only to traders is interest expense. Investors are limited to deducting interest expense incurred on debt used to finance their investment activities to investment income (gains, dividends and interest income). This limit on deducting interest expense to the extent of investment income, is not applicable to traders. Traders may deduct their interest expense as a deduction on Schedule C. Lastly, wash sale rules, which apply to investors, do not apply to traders. The wash sale rules require the deferral of trading losses, where the investor acquires substantially identical stock or securities within thirty days before or after a sale generating a loss.

So how do you make the leap once you have determined that you are in the business of trading?
Traders who desire to be treated at in the business of trading stocks make an election called the Mark-To-Market election by April15th of the current year. To be treated as a trader for 2010, a trader must make this election by April 15th, 2010, which is attached to either their 2009 Form 1040 or attached to their 2009 extension.
Election language:
Taxpayer hereby elects under IRC Sec. 475(f) to use the mark-to-market method of accounting for securities. This election will first be effective for the tax year ended December 31, 2010. The election is made for the following trades (list trades).

Once this election is made it is effective for all future tax years. The mark-to-market election requires traders to mark their stock holdings to market value at the end of the tax year. Once made, all security gains and losses are treated as ordinary income or losses and all trading securities on hand at the end of the year are deemed to be sold (and repurchased) at the year-end market value. All unrealized (unsold securities) gains and losses recognized under the mark-to-market election increase (unrealized losses) or decrease (unrealized gains) their basis in a given security.

Because making the mark-to-market election can have significant tax ramifications to future trading activities you should first consult with your CPA to determine if your trading activities meet the material participation test and, if so, if this election makes the most sense to your future trading business.