Friday, November 26, 2010
Brunson: Taxing Investors on a Mark-to-Market Basis
Although the U.S. tax system generally only taxes income on a realization basis (that is, when payment changes hands), mark-to-market accounting better reflects economic income. Although there are practical difficulties that compel the continued use realization accounting, the tax code in certain limited situations allows or requires taxpayers to recognize income or loss on a mark-to-market basis. For example, a trader in securities or commodities can make an election to mark gains or losses to the market. This election is not available, however, to investors who are not “traders” for tax purposes.
The Article demonstrates that there is no compelling tax policy reason to limit the availability of the mark-to-market election; rather, based on the superiority of mark-to-market accounting over the current realization regime, the policy justifications for allowing (and encouraging) taxpayers to determine their tax liability on a mark-to-market basis outweigh any objections to liberalizing the election’s availability.
Alternatively, the Article proposes a safe harbor that approximates the criteria courts look to in order to determine if a taxpayer is a trader, but that, unlike the current trade or business test, can be applied in advance of the taxable year. Although providing a safe harbor solely to traders is a worse solution than making the mark-to-market election available to all taxpayers, it is nonetheless better than the current unworkable criteria because it provides certainty to taxpayers at the time they must make the election.