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As advisors to people who are actively trading in recognized financial markets, we at Traders Accounting are constantly concerned with several issues.
First, we want to make sure our clients pay the absolute minimum amount of tax they lawfully owe.
That means we are always interested in making sure the client takes advantage of every deduction that is properly available.
Second, we want to have as much certainty as possible in the tax law. |
It is tough to advise a client as to that person’s legal rights when those legal rights are unclear. Clients hate to ask their tax advisor a question and get the response, “Maybe.” That may in fact be the correct response, but nobody likes hearing it—or delivering it, for that matter.
Those are some of the reasons why many clients are well-advised to conduct their trading business through one or more legal entities. This article addresses those reasons in depth and sets forth the points we consider when advising a client to structure with legal entities.
What is a Legal Entity?
A legal entity is an organization recognized by the IRS. A corporation, a limited partnership, and a non-profit are all examples of legal entities. Each legal entity is recognized by the IRS as a single body and is given a unique identification number, like an individual’s social security number.
Why is a Legal Entity More Beneficial than Filing as a Trader in Securities?
The number one reason for conducting your trading business within a legal entity is solidifying your business activities and expense deductions. In some situations, you can use a legal entity to convert personal expenses into deductible business expenses. If you’re like most traders, you’ll find that you can easily find deductions totaling thousands of dollars without breaking a sweat. For traders with substantial losses filing under the mark-to-market method of accounting, the waiver of the $3,000 capital loss limitation could be worth tens of thousands of dollars in tax savings. These savings are in jeopardy when you file, in your own name, as a Trader in Securities. At any moment, a new tax court ruling could re-define the definition of a Trader and upend your entire tax planning without any recourse for you.
The second biggest benefit of using a legal entity for your trading business is peace of mind. With a legal entity, you can lock in the business benefits of trading. Legal entities, unlike Traders in Securities status, are well defined by the IRS. You can be sure of the legal status conferred upon your business activities and business expenses.
Which Entity Should I Use for My Trading Business?
We do not believe that there is any one perfect entity or entity structure, which is why we compile a tax action plan to help you determine if the LLC or C corporation would work best for you, or some combination of both.
Who Should Use the LLC for Their Trading Business?
The IRS allows the LLC to be regarded as a “pass through” type of tax entity (like a Limited Partnership). That is, the profits or losses of the LLC pass through the business and are reflected and taxed on the individual tax returns of its owners, rather than being reported and taxed at a separate business level (as with a regular Corporation). The members (owners) of the LLC pay tax on their individual share of income of the LLC, and generally use any losses from the LLC to offset other personal income, and they use capital gains to offset any personal capital loss carryover.
Who Should Use the C-Corporation for Their Trading Business?
The C-corporation, alone, works well for those individuals who are not looking to take money out of their account and want to grow their wealth for long-term investing. The main advantage of the C-corporation is its favorable tax brackets. For example, instead of your trading gains being taxed at your personal tax rates, the first $50,000 of profits of a C-corporation are taxed at just 15%. Also, the C-corporation is unique in its ability to write-off 100% of all medical expenses by means of a self-insured medical reimbursement plan, including long-term care and other related expenditures. If you are in this situation, the C-corporation may be right for you.
Who Benefits from Using the C-Corporation in Combination with the LLC?
If you want to use a legal entity for your trading, and you want to take money out of your trading business without paying payroll taxes, and you will be trading less than 300 trades per year, the combination of the C-corporation and the LLC may be right for you. The C-corporation acts as the manager of the LLC trading business, and makes all trading and business decisions. As such, all of the expenses are run through the corporation. The LLC is used strictly for holding the brokerage account.
Where Should I Locate My Entity?
Any entity that is carrying on an active business needs to be registered within the state where business is conducted. As a general rule, when an entity has revenue and/or takes business deductions, it is carrying on an active business, and will need to be registered in its home state. If you pay payroll to fund your retirement account or medical insurance, you must register your business within the state where you live. In many cases, it’s best to set up the entity in the state where you live. In rare cases, you might consider a state that does not tax income for your trading entities.
What Accounting Method Should I Use?
When there is sufficient trading activity, you can adopt the mark-to-market method of accounting versus cash or accrual. Mark-to-market permits you to ignore both the Wash Sale Rule and the $3,000 cap on Capital Loss Deduction.
If you have large capital loss carryovers you may not want to take mark-to-market. Please consult with one of our tax consultants before you decide upon your accounting method. |
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Conclusion — the “Big Picture”
With all the details and rules involved, it is easy to lose the big picture when discussing entity structuring. That’s why it is always helpful to go back to the basics. Ask yourself, “Why should I structure my trading business with legal entities?” This article has addressed those reasons: legal entities afford a number of tax advantages to most traders. They may provide additional tax deductions, depending on your individual situation. They provide certainty in the tax law, reduce audit risk, provide asset protection, and they provide a means to get “earned income” so the trader can fund a pension plan and other benefits.
by Joe Wishcamper, Esq.
Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice. For further information please read our .
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