Business Incorporation Advantages for the Day Trader: Tax Status and Strategies for Minimizing Taxes
Traders Accounting does not use a cookie cutter approach for our trader's tax savings. Our recommendations are based on the information provided by the individual trader and our business incorporation services are tailored to meet the unique needs of each of our clients for tax efficiency. The first step in the process is to determine the trader's tax status; will they meet the definition of a trader in securities per IRS guidelines.
To determine whether an individual is in the business of trading, as a Sole Proprietor, the IRS looks at three main factors.
- You must seek to profit from daily market movements in the prices of securities,
- Your activity must be substantial, and
- You must carry on the activity with continuity and regularity.
In order to determine if the trader is following these conditions the IRS looks at the following facts and circumstances:
- Typical holding periods for securities,
- The frequency and dollar amount of trades,
- The extent to which you pursue the activity to produce income for a livelihood, and
- The amount of time devoted to the activity.
As a sole proprietor these vague guidelines leave many questions. How long can I hold my positions? How often do I have to trade? How many trades does it take to be considered substantial activity? If the market is not conducive to my trading strategy how long can I stay out of the market without bringing my continuity and regularity of trading into question?
These are a just a few examples out of a myriad of questions the IRS looks at to determine the trader's tax status. Unfortunately, the IRS does not seem interested in offering any help. Instead, they seem more than happy to leave it up to the courts to determine how these guidelines apply in the real world. While our tax court justices excel at interpreting tax law, it can be difficult to use their decisions to develop black and white rules as each individual circumstances are unique and may be interpreted differently.
Because of the uniqueness of each individual there is no one sure fire strategy to make a trader immune to the effects of murky tax law. We generally recommend that traders conduct their day trading business in a legal entity. When you set up a legal entity to trade in, the mere act of setting up the entity tells the IRS that you are going into the day trading business. That said, if you are a trader, you still must be an active-short term trader in an entity. You must also treat your trading as a business; learning to document your trading time, your expenses, and a few other matters.
While trading in a legal entity does not automatically guarantee that the IRS will consider the trading activity to be in the day trading business it does offer some other benefits. Generally, a legal entity files a separate income tax return from the individual. Filing a separate income tax return allows you to provide the IRS with a clearer picture of your trading business because the business activity is not co-mingled with individual activity on one return. The more clearly your information is presented to the IRS upfront the fewer problems you will have in the future. In addition forming a business entity can separate the business assets from the personal assets which may provide some asset protection depending on state law. Also, legal entities can allow traders to establish benefits that are traditionally associated with businesses such as 401(k) plans. These are just a few benefits that legal entities can provide. For more information on our business structuring service and how an entity can benefit you specifically please click on the "get started" button on the right.
Common Legal Entities
Limited Liability Company (LLC): An LLC taxed as a partnership is a popular choice of entities. To be taxed as a partnership the LLC must have at least two members. The LLC, taxed as a partnership, is a pass-through entity. This means that while the LLC files its own return the income or loss from trading flows to the members and is reported on the members' individual income tax returns. The LLC allows the members to take distributions of capital which provides a method of taking money out of the LLC without having to pay payroll taxes. In addition, the trading income from a LLC is not subject to self employment tax. Don't be confused by Single Member LLCs (SMLLC). When you trade through a SMLLC, the IRS considers your SMLLC a disregarded entity for tax purposes. This causes you to file a Schedule C on your individual income tax return, thus you are effectively trading as a sole propriertor.
LLC files its own return the income or loss from trading flows to the members and is reported on the members' individual income tax returns. The LLC allows the members to take distributions of capital which provides a method of taking money out of the LLC without having to pay payroll taxes. In addition, the trading income from a LLC is not subject to self employment tax. Don't be confused by Single Member LLCs (SMLLC). When you trade through a SMLLC, the IRS considers your SMLLC a disregarded entity for tax purposes. This causes you to file a Schedule C on your individual income tax return, thus you are effectively trading as a sole propriertor.
S-Corporation: We generally do not recommend the use of an S Corporation for trading however, depending on the individual facts and circumstances they may beneficial. S Corporations are pass-through entities, which means income or loss flows through to the individual. If an S Corporation makes a profit it is required to pay the owners a reasonable salary subjecting the business to payroll reporting. When this happens, of course you must pay payroll taxes (15.3%). As stated above in the LLC information, when you trade in an LLC taxed as a partnership you are not subject to payroll or payroll tax.
C-Corporation: The C Corporation is frequently used for its ability to offer benefits, such as Medical Reimbursement Plans, which do not work well in pass-through entities. The C Corporation is a standalone entity which means the income from trading is taxable to the C Corporation and does not flow through to the individual owners. Profits are generally removed from the C Corporation through salary or dividends.
Combination Structure: In some cases we recommend that the trader establish two legal entities. Generally, the combination structure is composed of a C Corporation and an LLC. The combination structure is used in very limited circumstances to utilize the advantages of each type of business.