                          T.C. Memo. 2011-159



                        UNITED STATES TAX COURT



                 RICHARD KAY, JR., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 18203-09.                Filed July 6, 2011.



     Richard Kay, Jr., pro se.

     Mindy S. Meigs, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:    Respondent determined deficiencies and

penalties as follows:

                                          Penalty
               Year        Deficiency   Sec. 6662(a)

               2001         $131,693    $26,338.60
               2002           90,020     18,004.00
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The issues for decision are:   (1) Whether petitioner was a trader

in securities during 2000, 2001, and 2002; (2) whether petitioner

is entitled to claim a net operating loss (NOL) carryover from

2000 in 2001 and 2002; (3) whether petitioner must include a

State income tax refund in his taxable income in 2002; and (4)

whether petitioner is liable for the penalties under section

6662.   Unless otherwise indicated, all section references are to

the Internal Revenue Code (Code) in effect for the years in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.   At the

time the petition was filed, petitioner resided in California.

     Petitioner holds a degree in economics from San Diego State

University.   During the years in issue, petitioner operated a

ball bearing manufacturing and distribution business, Clean Wave

Management, Inc. (Clean Wave), an S corporation.   Petitioner has

been Clean Wave’s sole shareholder, officer, and director from

the date of its incorporation in 1995 to the present.   During the

relevant period, petitioner resided in one unit of a duplex, with

Clean Wave operating out of the other unit.   Clean Wave had three

additional employees who worked with petitioner throughout the

years in issue.
                                   - 3 -

        On his 2000-2002 Forms 1040, U.S. Individual Income Tax

Return, as amended, petitioner reported wages paid by Clean Wave

of $36,400, $43,600, and $52,000 respectively.      On Clean Wave’s

2000-2002 Forms 1120S, U.S. Income Tax Return for an S

Corporation, as amended, the corporation reported net income of

$657,683, $385,270, and $278,213.

     Petitioner traded securities prior to and throughout 1999-

2002.     Petitioner made a mark-to-market election under section

475(f) in 1999 and did not revoke that election through 2002.

     The number of days petitioner traded securities and the

number of transactions he engaged in from 2000-2002 was as

follows:

           2000                    2001                  2002
     Trading Activity       Trading Activity     Trading Activity
     Trading    No. of      Trading     No. of   Trading    No. of
       Days     Trans.        Days      Trans.     Days     Trans.

Jan.       4        11        0            0        1         4
Feb.       9        50        1            2        2         8
Mar.       7        17        0            0        5         14
Apr.       8        62        0            0        2         14
May        3        15        0            0        2         7
June1      1        4         0            0        3         5
July       7        38        1            1        6         32
Aug.       6        24        0            0        0         0
Sept.      3        14        2            16       0         0
Oct.       6        13        6            28       0         0
Nov.       11       32        3            5        0         0
Dec.       8        33        5            20       0         0
  Total    73      313        18           72       21        84
     1
      The record does not include complete information for June
2000. The totals include the data that is available in the
record. On the basis of what the record does provide, the
missing data would not have significantly changed the number of
days petitioner traded securities or the number of transactions
he completed.
                               - 4 -

There were 252 total trading days in 2000 and 2002, and 248

trading days in 2001.

     In 2000, the total value of the securities petitioner

purchased was over $20 million, and the total value of the

securities petitioner sold was also over $20 million.    Petitioner

bought and sold the same stock on the same day on only six

occasions in 2000.   In 2001, the total value of the securities

purchased and sold was $2,349,320.35 and $1,576,548.02

respectively.   He bought and sold the same stock on the same day

on only four occasions in 2001.    In 2002, the total value of the

securities purchased and sold was $1,234,427.90 and $1,852,167.29

respectively.   He bought and sold the same stock on the same day

on only three occasions in 2002.

     Petitioner attached a Schedule C, Profit or Loss From

Business, to his 2000 Form 1040 where he reported his income,

losses, and expenses from his sales of securities.    On that form

he listed his principal business or profession as “DAY TRADE”.

On his 2000 Schedule C, petitioner reported a net loss of

$2,052,637, arising from $1,960,060 in losses from sales of

stocks and $92,577 in expenses.    Petitioner offset other ordinary

taxable income by deducting some of these losses.

     On his amended 2001 Schedule C, petitioner reported a net

loss of $399,740, arising from $399,162 in losses from the sale
                                 - 5 -

of stocks and $578 in expenses.     He also reported an NOL of

$1,396,943 carried over from 2000.

     On his 2002 Schedule C, petitioner reported a net loss of

$278,297, arising from $262,921 in losses from the sale of stocks

and $15,376 in expenses.     On his 2002 return, he also reported

the same $1,396,943 NOL carried over from 2000, some of which he

used to offset other ordinary income.

     Petitioner claimed a deduction of $21,806 for State and

local income taxes on his 2001 return.     At the time he filed his

return he reported a negative income and thus did not receive a

tax benefit from the deduction.    However, in the notice of

deficiency, the IRS disallowed the ordinary losses for 2001 as

described above.     Consequently, the notice of deficiency included

an additional $16,059 of income in 2002 after the IRS became

aware that during 2002 petitioner had received a refund of that

amount from his State taxes.

                                OPINION

Trading Activities

     Respondent disallowed deductions for ordinary losses beyond

the limit of $3,000 under section 1211(b) for losses arising from

petitioner’s trading of securities during 2001 and 2002.       See

sec. 165(f).   Respondent also disallowed deductions for an NOL

carried over from 2000 to the years in issue arising from similar

trading activity.     We may determine the correct amount of taxable
                               - 6 -

income or NOL for a year not in issue (whether or not the

assessment of a deficiency for that year is barred) as a

preliminary step in determining the correct amount of an NOL

carryover to a taxable year in issue.     Lone Manor Farms, Inc. v.

Commissioner, 61 T.C. 436, 440 (1974), affd. without published

opinion 510 F.2d 970 (3d Cir. 1975).

     In general, for Federal tax purposes, a person who purchases

and sells securities falls into one of three distinct categories:

dealer, trader, or investor.   See King v. Commissioner, 89 T.C.

445, 458-459 (1987).   The parties have not argued that petitioner

was a dealer for the years in issue.

     Section 475(f) provides generally that a taxpayer engaged in

business as a securities trader may elect to use the

mark-to-market method of accounting for securities held in a

business.   Under the mark-to-market method of accounting a

taxpayer generally recognizes at the end of the year ordinary

gain or loss on all securities held in the business as if the

securities were sold at the end of the year for fair market

value.   Sec. 475(d)(3), (f)(1)(A)(i); Lehrer v. Commissioner,

T.C. Memo. 2005-167, affd. 279 Fed. Appx. 549 (9th Cir. 2008).

Ordinary losses are thereby made available to offset ordinary

income and are not subject to the $3,000 limitation, as relevant

here, imposed by section 1211(b) on the deduction of capital

losses in excess of capital gains.     See Vines v. Commissioner,
                                 - 7 -

126 T.C. 279, 288 (2006).     Petitioner made a timely

mark-to-market election pursuant to section 475(f).      However,

section 475(f) applies only to those engaged in a trade or

business as traders in securities.

     Traders are engaged in the trade or business of selling

securities for their own account.     See King v. Commissioner,

supra at 457-458.    Investors likewise buy and sell for their own

account, but they are not considered to be in the trade or

business of selling securities.     See Arberg v. Commissioner, T.C.

Memo. 2007-244.   Unlike an investor, a trader’s expenses are

deducted in determining adjusted gross income rather than as

itemized expenses.     Whether petitioner’s activities constituted a

trade or business is a question of fact.    See Higgins v.

Commissioner, 312 U.S. 212, 217 (1941); Cameron v. Commissioner,

T.C. Memo. 2007-260.

     In determining whether a taxpayer is a trader, nonexclusive

factors to consider are:    (1) The taxpayer’s intent, (2) the

nature of the income to be derived from the activity, and (3) the

frequency, extent, and regularity of the taxpayer’s securities

transactions.    Purvis v. Commissioner, 530 F.2d 1332, 1334 (9th

Cir. 1976), affg. T.C. Memo. 1974-164.     For a taxpayer to be a

trader, the trading activity must be substantial, which means

“‘frequent, regular, and continuous enough to constitute a trade

or business’”.    Ball v. Commissioner, T.C. Memo. 2000-245
                               - 8 -

(quoting Hart v. Commissioner, T.C. Memo. 1997-11).     A taxpayer’s

activities constitute a trade or business where both of the

following requirements are met:   (1) The taxpayer's trading is

substantial, and (2) the taxpayer seeks to catch the swings in

the daily market movements and to profit from these short-term

changes rather than to profit from the long-term holding of

investments.   King v. Commissioner, supra at 458-459; Mayer v.

Commissioner, T.C. Memo. 1994-209.

     With respect to the first requirement, when evaluating

whether a taxpayer’s trading activities were substantial we have

considered the number of executed trades in a year and the amount

of money involved in those trades.     When the number of trades

made and the amount of money involved in those trades is small in

a given year, a taxpayer’s trading activity is insubstantial.

See Moller v. United States, 721 F.2d 810, 813-814 (Fed. Cir.

1983) (finding 124 trades in one year and 106 trades in the

following year was insubstantial); Holsinger v. Commissioner,

T.C. Memo. 2008-191 (finding 289 trades with aggregate sales of

$754,277 in one year at issue was insubstantial).    When the

number of trades and the amount of money involved in those trades

is large, a taxpayer’s trading activity is substantial.    See

Mayer v. Commissioner, supra (1,100 sales and purchases with

gross receipts of more than $10 million in each year at issue was

substantial); Paoli v. Commissioner, T.C. Memo. 1991-351 (326
                                 - 9 -

sales of stocks with gross receipts of more than $9 million in

the year at issue was substantial).

     We have also considered the amount of time petitioner spent

buying and selling securities.    A taxpayer’s trading activity is

insubstantial when the taxpayer trades only for a small portion

of the trading days in the particular year.   See Holsinger v.

Commissioner, supra (finding “it doubtful whether the trades were

conducted with the frequency, continuity, and regularity

indicative of a business” when trades occurred on approximately

40- to 45-percent of the trading days in the years at issue).     In

addition, a taxpayer engaged in sufficiently substantial trading

activity to qualify as a trade or business will generally rely on

that activity as their sole or primary source of income.   See

Chen v. Commissioner, T.C. Memo. 2004-132.

     With respect to the second requirement for classification as

a trader, a taxpayer must have sought to profit from short-term

swings in the stock market.   See Mayer v. Commissioner, supra.

Thus, investors generally hold securities for relatively long

periods of time while traders hold securities for short periods.

See Holsinger v. Commissioner, supra (holding that taxpayers did

not demonstrate that they sought to profit from short-term swings

in the market because they rarely bought and sold the same stock

on the same day and held a significant amount for more
                               - 10 -

than 31 days); see also Estate of Yaeger, T.C. Memo. 1988-264,

affd. 889 F.2d 29 (2d Cir. 1989).

     The number of trades petitioner engaged in during the years

2000, 2001, and 2002 was not substantial.    In 2000, 2001, and

2002, petitioner executed 313 trades, 172 trades, and 84 trades

respectively.   We found similar numbers of trades to be

insubstantial in the cases discussed above.    In 2000, however,

the total amount of money involved in trading was substantial.

In that year, petitioner made over $20 million in purchases and a

similar amount in sales.    In 2001 and 2002, petitioner’s gross

purchases and gross sales, which ranged between $1 million and

$2.5 million, were less substantial.    In any case, managing a

large amount of money is not conclusive as to whether

petitioner’s trading activity amounted to a trade or business.

See Moller v. United States, supra at 814.

     Petitioner’s trading activity was infrequent.    In the years

2000, 2001, and 2002, petitioner conducted trading activity on

just 29 percent, 7 percent, and 8 percent of the possible trading

days in each year, respectively.    Income from Clean Wave was his

primary source of income.   Despite petitioner’s assertion that he

spent the majority of his time as a day trader, the number of

days he actually made trades show otherwise.

     Petitioner generally did not hold stocks for intervals that

demonstrate an intention to profit from day trading.    The
                               - 11 -

majority of the stocks he purchased and sold in each of the years

at issue were held for over 30 days.    Petitioner rarely purchased

and sold the same stock on the same day.

     Overall, petitioner has not met the requirements for his

trading activity to be treated as a trade or a business.    Thus he

is limited to a $3,000 deduction of losses arising from the

purchase and sale of securities in 2001 and 2002 under section

1211(b) and may not carry forward the NOL generated in 2000.

State Income Tax Refund

     Petitioner bears the burden of proving that the

determination of unreported income in the notice of deficiency is

erroneous.    See Rule 142(a); Welch v. Helvering, 290 U.S. 111,

115 (1933).

     Generally, under section 111 and the regulations thereunder,

if a tax was deducted on a prior year’s return that resulted in a

reduction of tax and a tax benefit to the taxpayer, the

taxpayer’s subsequent recovery of the tax must be included in

gross income in the year the recovery is received.     Prewitt v.

Commissioner, T.C. Memo. 1995-24; Kadunc v. Commissioner, T.C.

Memo. 1992-61, affd. without published opinion 981 F.2d 1251 (4th

Cir. 1992).

     Petitioner reported a deduction for State income taxes of

$21,806 on his 2001 tax return.   Because we here determine that

his income in 2001 was not offset by the securities trading
                                - 12 -

losses, he will receive a tax benefit from that deduction.

Petitioner did not address this issue in the petition or at trial

and did not submit any briefs.    Accordingly, as respondent

determined in the notice of deficiency, the refund of State

income tax received in 2002 is includable in gross income for

that year.

Accuracy-Related Penalty

     Section 6662(a) and (b)(1) and (2) imposes a 20-percent

accuracy-related penalty on any underpayment of Federal income

tax attributable to a taxpayer’s negligence or disregard of rules

or regulations or substantial understatement of income tax.

Section 6662(c) defines negligence as including any failure to

make a reasonable attempt to comply with the provisions of the

Code and defines disregard as any careless, reckless, or

intentional disregard.     Disregard of rules or regulations is

careless if the taxpayer does not exercise reasonable diligence

to determine the correctness of a return position that is

contrary to the rule or regulation.      Sec. 1.6662-3(b)(2), Income

Tax Regs.    A substantial understatement of income tax exists if

the understatement exceeds the greater of 10 percent of the tax

required to be shown on the return or $5,000.     Sec.

6662(d)(1)(A).

     Under section 7491(c), the Commissioner bears the burden of

production with regard to penalties and must come forward with
                              - 13 -

sufficient evidence indicating that it is appropriate to impose

penalties.   See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

However, once the Commissioner has met the burden of production,

the burden of proof remains with the taxpayer, including the

burden of proving that the penalties are inappropriate because of

reasonable cause or substantial authority.   See Rule 142(a);

Higbee v. Commissioner, supra at 446-447.    Considering the

erroneous nature of the deductions and the amounts of the

resulting underpayment of tax, respondent has satisfied the

burden of producing evidence that the penalty is appropriate for

2001 and 2002.

     The accuracy-related penalty under section 6662(a) is not

imposed with respect to any portion of the underpayment as to

which the taxpayer acted with reasonable cause and in good faith.

Sec. 6664(c)(1); Higbee v. Commissioner, supra at 448.    The

decision as to whether a taxpayer acted with reasonable cause and

in good faith is made on a case-by-case basis, taking into

account all of the pertinent facts and circumstances.    See sec.

1.6664-4(b)(1), Income Tax Regs.

     Petitioner does not separately address the penalty issue.

He failed to allege that the Commissioner’s imposition of a

penalty was erroneous in his petition, and the issue is therefore

deemed conceded.   See Rule 34(b)(4); Swain v. Commissioner, 118

T.C. 358, 363-365 (2002).   In any event, petitioner has not
                                - 14 -

demonstrated reasonable cause.    Petitioner is a sophisticated

investor, but his references to his accountant at trial were

insufficient to prove that he relied on professional advice or

otherwise sought to determine the appropriate tax treatment of

his transactions.   Petitioner is liable for the penalty for 2001

and 2002.

     We have considered the other arguments of the parties, and

they either are without merit or need not be addressed in view of

our resolution of the issues.    For the reasons explained above,


                                         Decision will be entered for

                                 respondent.
