You have choices, and as an individual retail trader you have a choice. You can choose to trade as an individual, without any of the asset protections and tax advantages that come with a legal business structure, and choose to put yourself in a hole before you make a single dollar in profit. Or you can choose to put in place a legal structure that will protect your assets and allow you to take significant deductions that could be the difference between success and failure as a trader.
How The IRS Looks At Traders
As an active trader you can elect to have Trader Status in the eyes of the IRS, and in doing so you need to qualify, with some level of interpretation, that you are an active day trader. In IRS Publication 550 and Revenue Procedure 99-17, the IRS has set general guidelines that provide guidance. IRS Publication 550 explains what investment expenses are deductible, when gains and losses from the sale of investment property are to be reported and what type of investments are considered taxable.
This is probably not the definition that most traders qualify for. And it doesn’t provide any flexibility should you decide to change your legal structure later on. Once you elect Trader status, you need to comply with this publication. I recommend you read it. Here’s a synopsis. After which I’ll describe a better alternative in my opinion.
Individuals who elect Trader Status are assumed to make multiple trades daily and do so continuously throughout the year. They spend a considerable amount of time documenting and researching trades and strategies and incur a significant amount of expenses in order to conduct their business activities. Although not specifically required, most qualified traders will open and close multiple trades daily and hold their positions for less than 30 days.
The qualified trader is allowed to file a Schedule C and deduct business expenses, which includes education, entertainment, margin interest and other trading-related expenses. You can also take a Section 179 deduction and write off of up to $19,000 a year for computers and other equipment used in trading activities.
A qualified trader can elect a Section 475(f) or the mark to market (MTM) accounting method. Under MTM, traders aren’t bound by the $3,000 net capital loss limit and can deduct all losses in the year they occur, providing the maximum tax relief for that year. This also allows traders to avoid the 30-day wash sale rule.
For active traders, these benefits are obvious, but these guidelines are open to interpretation by the IRS and the courts. Only a small percentage qualify, even some whose only income is derived through trading. That’s a big gotcha!
A Better Trader Business Structure
You can receive the same tax advantages as a qualified trader by creating a corporate entity to trade through, such as a Limited Liability company or Limited Partnership. You’ll receive the same tax benefits without having to qualify.
The legal entity receives less scrutiny from the IRS because they assume that no one would go through the trouble and expense of forming the entity, unless they were committed to trading as a business venture. But the truth is, creating a legal entity is a piece of cake. Here’s the big difference, it’s extremely difficult to change elections such as MTM once chosen. With the company, if there is an advantage to changing accounting methods or legal structure, you can simply dissolve the company and re-form it.
More Options As Your Trading Business Grows
As your business grows you can setup more legal entities to take advantage of a myriad of tax benefits and strategies. You could have a separate company for each primary strategy you employ, and create a general partner as a C Corporation that oversees each of the LLC’s. By doing this, income from one of the LLCs (up to 30%) can be transferred to the General Partner corporation to take advantage of additional tax strategies.
And there’s more. You could list family members as employees and take advantage of deductions like salaries, health care, educational expenses, and retirement accounts. You could even create reimbursement plans to fund medical insurance premiums.
Your retirement accounts, like IRAs and 401(k)s, can be transferred into a 401a, a type of pension fund that allows contributions of up to $49,000 per year that can never be attacked by creditors or legal claims. Because a corporation pays taxes on net income, the goal is to pay as many expenses as possible with pretax dollars and to minimize taxable income. The true benefit of having your own company, avoiding taxes and keeping more of your money in your pocket.
A corporate business structure provides excellent asset protection because it separates the business from the individual. Long-term assets can be held by one of your LLCs that can use accounting methods better suited for investments. All assets are protected from creditors and the legal liabilities of the individual because they are held by separate legal entities.
Is it all peaches and cream having all this legal structure and complexity, of course not, but that’s what accountants are for. And the fee you pay them is also tax deductible. The money you spend on an accountant and a good corporate lawyer will pay for itself many times over. For traders who are profitable but cannot or don’t want to qualify for trader status, trading through a simple business is absolutely essential. To get the best tax advice and legal protection, you should speak with professionals who understand the formation and operation of legal entities for traders.