March 20, 2025
Re: § 58.1-1821 Application: Individual Income Tax
Dear *****:
This will respond to your letter in which you seek correction of the individual income tax assessment issued to ***** (the “Taxpayer”) for the taxable year ended December 31, 2020.
FACTS
The Taxpayer filed a Virginia resident income tax return for the 2020 taxable year, claiming cost of goods sold (COGS) and other expenses on federal Schedule C. Under audit, the Department requested documentation to support the amount claimed as COGS. The Taxpayer submitted some documentation, but the auditor determined it was insufficient. The Department, accordingly, disallowed the COGS and issued an assessment. The Taxpayer filed an application for correction, contending he is an options trader and is entitled to deduct his trading losses as ordinary losses.
DETERMINATION
Conformity
Virginia Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia. For individual income tax purposes, Virginia conforms to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Chapter 3 of Title 58.1 of the Code of Virginia.
As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. The Department, however, retains the authority to adjust the FAGI and itemized deductions where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Virginia Code § 58.1-219. The Department has regularly exercised this authority in conducting its audit programs. See Public Document (P.D.) 10-126 (07/07/2010), P.D. 12-141 (08/29/2012), P.D. 14-155 (08/28/2014), P.D. 16-53 (04/11/2016), P.D. 19-104 (09/18/2019), and P.D. 21-67 (05/25/2021).
Cost of Goods Sold
Schedule C is used to report income or loss from a business, including a sole proprietorship. Gross receipts are reduced by returns and allowances and COGS to determine gross income. See Treas. Reg. § 1.61-3. Gross income is offset by expenses to determine net profit or loss. This income or loss is reported on a taxpayer’s federal income tax return and thus is reflected in FAGI reported on the Virginia return.
COGS includes the direct costs of producing or purchasing the goods or services sold to customers by a business and is determined in accordance with a taxpayer’s method of accounting. See id. If a business does not sell goods or services to customers, by definition, it will not have COGS. In addition, taxpayers cannot claim COGS in the absence of gross receipts or sales. See, e.g., Weaver v. Comm’r, 87 T.C.M. (CCH) 1259 (2004).
IRC § 471 and the accompanying regulations generally prescribe the rules relating to determining COGS and inventories. See generally BRC Operating Co. LLC v. Comm’r, 121 T.C.M. (CCH) 1442 (2021). Treas. Reg.§ 1.471-5 permits dealers in securities to account for unsold inventories of securities using several possible methods, including at cost. For this purpose, a dealer in securities is defined as a merchant of securities that regularly purchases and resells securities to customers. See id.
In this case, the Taxpayer bought and sold securities for his own account and did not sell goods or services to customers or report any gross receipts. Therefore, the Department’s disallowance of the amount the Taxpayer claimed as COGS was correct. The Taxpayer, however, argues that even if he should not have reported the cost of the securities he purchased as COGS, it was merely a clerical mistake and his losses on the disposition of the securities should otherwise be allowed to fully offset his income. Addressing this argument requires further analysis of the income tax rules applicable to securities traders and investors.
Income or Loss from Securities
Most taxpayers who buy or sell securities are investors who report their income or loss as capital gains and losses for federal income tax purposes. Special rules apply to taxpayers who qualify as traders or dealers in securities under IRC § 475. Securities include shares of stock, certain partnership interests, evidence of indebtedness, and interests in derivative financial interests such as options, forward contracts, and short positions, with the exception of certain hedging transactions. See IRC § 475(c)(2). In this case, the Taxpayer primarily invested in options and other derivative contracts. The amounts claimed on Schedule C as COGS resulted when he was required to purchase stock to cover his option positions. The Taxpayer had losses attributable to his brokerage liquidating certain stock positions when he did not have sufficient capital to make stock purchases required under his option contracts. As discussed above, the Taxpayer originally claimed these losses as COGS but now claims they should be allowable as a deduction against his ordinary income.
A person who is engaged in a trade or business as a trader in securities may elect to report their gains and losses from trading in securities as ordinary income and loss and apply the mark-to-market method of accounting to the securities they hold at the end of the taxable year. This method of accounting treats end-of-year holdings as being sold on the last day of the tax year resulting in ordinary income or loss. Income or loss recognized, or deemed recognized, must be reported by the trader on federal Form 4797 (Sales of Business Property). The election under IRC § 475(f) must be made by attaching a statement to the return for the taxable year immediately preceding the taxable year for which the election is to be effective, or to a request for an extension of time to file such return. See Rev. Proc. 99-17, 1999-1 C.B. 503.
In order to qualify as a trader eligible to make an election under IRC § 475, a taxpayer must seek to profit from daily market movements and their trading activity must be both substantial and carried on with continuity and regularity. See generally Assaderaghi v. Comm’r, 107 T.C.M (CCH) 1179 (2014). Even if the Taxpayer was a trader qualified to make the election, he has not presented any evidence that he made a valid mark-to-market election under IRC § 475(f).
In the absence of a valid mark-to-market election, a trader must report their income from securities in the same manner as investors. Gains and losses from the sale of securities are treated as capital in nature. Capital gains are generally eligible for favorable tax treatment and capital loss deductions are limited to offsetting capital gains except that taxpayers may use $3,000 of capital losses to offset ordinary income each year. Unused capital losses may be carried over and used to offset future capital gains and up to $3,000 of ordinary income annually. See IRC § 1211, et seq. In this case, the Taxpayer reported a capital loss carryover on his 2020 federal Schedule D (Capital Gains and Losses). The capital losses resulting from the Taxpayer’s options trading activities in the 2020 taxable year also should have been reported on federal Schedule D, resulting in an increased capital loss available to be carried over to future years.
As discussed above, securities do not include certain hedging transactions which are taxed to both investors and traders on a mark-to-market basis by operation of law without the need for a special election. See Treas. Reg. § 1.1221-2. The Taxpayer’s brokerage reporting documents for the 2020 taxable year listed losses from regulated futures contracts which were properly reportable as ordinary losses on federal Form 6781 (Gains and Losses From Section 1256 Contracts and Straddles). Only such losses were eligible to be deducted from ordinary income.
CONCLUSION
As discussed above, the Taxpayer was not eligible to claim COGS on his Schedule C. In addition, the Taxpayer’s claim that the assessment should be abated because he was a trader and entitled to an ordinary loss is without merit. Even if the Taxpayer qualified as a trader under federal law, there is no evidence that he made a proper election under IRC 475(f) and thus would not be eligible to treat his trading losses as ordinary losses. Accordingly, there is no basis to abate the Department’s assessment for the 2020 taxable year. The Department will, however, adjust the assessment to allow the loss attributable to his hedging transactions.
The Taxpayer will receive an updated bill that will include accrued interest to date. The Taxpayer should remit the balance due within 30 days of the bill date to avoid the accrual of additional interest and possible collection actions.
The Code of Virginia sections cited are available online at law.lis.virginia.gov. The public documents cited are available at tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy and Legal Affairs, Tax Adjudication and Resolution Division, at *****.
Sincerely,
James J. Alex
Tax Commissioner
Commonwealth of Virginia
AR 4771.X