Once you achieve Trader Status then you can now take full advantage of business expense treatment and mark-to-market elections. Entities are also a great idea for traders who have other sources of income or are trading on a part-time basis. Additionally, it is important to segregate investments from business trading when claiming trader status, an entity helps segregate those items.
Assuming you qualify for Trader Status there are many advantages to setting up a trading entity. But first lets take a look at the current options available to traders.
Sole Proprietorship
An unincorporated business with a single owner who pays personal income tax on profits earned from the business. With little government regulation, a sole proprietorship is the simplest business to set up or take apart, making sole proprietorship’s popular among individual self-contractors, consultants or small business owners. Many sole proprietors do business under their own names because creating a separate business or trade name isn’t necessary.
Trader Tax Tip: Active traders who trade as sole props report business expenses on Schedule C while trading income/losses are reported on other tax forms which can cause confusion with the IRS The IRS may automatically view a trading businesses Schedule C as unprofitable even if it has achieved profitability. This creates an additional incentive for a trader to create an entity.
Limited Liability Company
A limited liability company is a corporate structure whereby the members of the company are not personally liable for the company’s debts or liabilities. Limited Liability companies are hybrid entities that combine the characteristics of a corporation and a partnership or sole proprietorship. While the limited liability feature is similar to that of a corporation, the availability of flow-through taxation to the members of an LLC is a feature of partnerships.
Trader Tax Tip: Active traders who trade as SMLLCs (Single Member LLC) report business expenses on Schedule C while trading income/losses are reported on other tax forms which can cause confusion with the IRS. If a trader establishes a Single Member LLC ( by default the IRS views this as a disregarded entity and is treated as a sole proprietorship for tax purposes.) A SMLLC will need to file documentation with the IRS to change the default tax status.
Partnerships
A partnership is a formal arrangement in which two or more parties cooperate to manage and operate a business. Various partnership arrangements are possible in which all partners might share liabilities and profits equally or some partners may have limited liability. Not every partner is necessarily involved in the management and day-to-day operations of the venture, such as in the case of a “silent partner.” In some jurisdictions, partnerships enjoy favorable tax treatment relative to corporations.
Trader Tax Tip: Active traders who are structured as multi-members LLCs or General Partnerships file taxes on Form 1065, making life easier for you. Form 1065 issues a Schedule K-1 to all owners according to ownership %, and taxes are paid at the owner level rather than at the entity level avoiding double taxation. Net Income is summarized on Schedule E rather than in full detail on a schedule C used by sole proprietorship. Certain states offer favorable tax treatment for General Partnerships. Note a 1065 does not unlock employee benefit plans or 401(k) contributions.
S-Corporation
A Subchapter S (S Corporation) is a form of corporation that meets specific Internal Revenue Code requirements. The requirements gives a corporation with 100 shareholders or fewer the benefit of incorporation while being taxed as a partnership. The corporation may pass income directly to shareholders and avoid double taxation. Requirements include being a domestic corporation, not having more than 100 shareholders, which includes only eligible shareholders, and having only one class of stock.
Trader Tax Tip: Multi-Member LLC and an SMLLC can elect S-Corp tax treatment within 75 days of inception. Active traders who elect to be taxed as S-Corporations can arrange employee benefit plan (IRA) & health insurance premium deductions. Note a base salary is needed for covering deductions and health insurance premiums. If you have large trading gains the elective deferral is $18,500 for 2018 and 25% max profit share for a total contribution of $55,000. Note a base salary is needed for covering the health insurance premium / retirement deduction. An S-Corporation is a tax free entity for federal tax purposes and some states have some taxes assessed and annual reporting fees.
C-Corporation
A C corporation is a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation. The taxing of profits from the business is at both corporate and personal levels, creating a double taxation situation.
Trader Tax Tip: Many Active traders inquire about utilizing a C-Corporation for trading or a dual entity type structure. In a dual entity type structure (C-Corporation management company w/ an LLC) sometimes it works if you can get the right amount of income into the management company to maximize employee benefit plans, compensation, and desired net income. As trading gains typically fluctuate throughout each quarter we typically steer traders away from the C-Corp type structure for a variety of reasons but mainly because C-Corps are subject to double taxation — once on the entity level and a second time at the shareholder level.
Final Thoughts
There is no one size fits all entity solution for a trader. Each trader brings forth a different set of facts and circumstances so what may work for one trader may not work for the next. If you have questions feel free to reach out to our firm for a consultation. Additionally, if you decide to form an entity outside of your home state; your home state might require a foreign entity registration. Setting up a mail box in a tax-free state does not achieve tax nexus, whereas, trading from your home state does. When preparing your entity tax returns don’t try to avoid state level taxation. For example if you form an entity in Nevada but live and trade in California, then California may charge the LLC tax, fees, and penalties.