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| The Godfather’s Advice on the Personal Holding Company Tax? Forget About It! |
05-10-2007 |
The various “Godfather” books and movies were an early primer on how life
works. Big organizations, whether the Mafia or the United States government,
require a cut of our action in exchange for the services they provide. Vito
Corleone would refer to this as “a little taste.” The IRS simply calls it taxes.
Traders Accounting closely monitors tax law changes and taxation trends with
a critical eye to their potential impact on traders, in order to assure that you
never pay more than your fair “taste” to the taxman.
Unfortunately, some Certified Public Accountants who are less conversant with
the intricacies of the unique trader tax status have lately taken to the odd
practice of recommending that you switch from a C Corporation to an S
Corporation in order to avoid the personal holding company tax, or PHC.
We say odd because traders by definition are not subject to the personal
holding company tax, regardless of their choice of corporate entity.
Form an S Corporation to avoid the PHC? As the Godfather would say, forget
about it!
To Have and (Not) Hold
Let’s face it: with the exception of our trader/accountant experts at Traders
Accounting, most accountants do not understand the trading business. That said,
the tax code makes it awfully easy for accountants to confuse trading with
investing. The IRS so far has declined to clearly define what constitutes a
trader, leaving it to case law to provide the tenuous framework for trader tax
status.
The PHC is a stiff penalty tax of 35% levied on C Corporations if 60% or more
of their adjusted gross income qualifies as personal holding company income,
such as dividends, interest and capital gains. That steep fine has prompted some
ill-informed accountants to recommend an S Corporation to their C Corporation
traders.
But the operative word in the personal holding company tax is holding.
Traders must meet strict IRS guidelines to obtain trader tax status. One of the
chief tests is that you must seek to profit from the daily movements of the
market and not from dividends, interest or capital appreciation.
In other words, by definition, most of a trader’s income cannot be personal
holding company income. If it is, you will almost certainly not be considered a
trader in the eyes of the IRS for long.
Sign Your Name with Inc.
It does however make dollars - and sense - to trade under a business entity.
By forming a legal entity and choosing the mark-to-market accounting method, you
can convert personal expenses into deductible business expenses that can easily
add up to $10,000-$20,000 annually. Should you experience substantial losses,
you’ll be able to fully deduct those as ordinary losses as well, and not be
restricted as sole proprietors are to the $3,000 capital gains cap.
While simpler “flow-through” entities such as general and limited
partnerships and limited liability companies are appropriate for most traders,
some traders like the perks, flexibility and stability that a C Corporation can
provide. (Traders Accounting does not recommend S Corporations for most traders
because the tax courts have ruled that you must take at least half of your
profit in corporate payroll, at a 15.2% tax rate. Other entities such as an LLC
do not have this requirement.)
As a solo C Corporation, you can:
- Protect your personal assets
- Take the maximum allowable business deductions, including 100% of your
medical bills, including medical insurance, co-pays, deductibles, even many of
the over-the-counter items you buy at the drug store
- Deduct $5,000 of your pre-existing start-up expenses and depreciate the
remainder. Average Traders Accounting clients save $10,000 to $20,000 on this
deduction alone.
- Establish a medical reimbursement plan, or MRP, and thereby deduct 100% of
your medical insurance premiums, out-of-pocket expenses, deductibles and even
uninsured health and accident expenses
- Shift income between the corporation and shareholders to minimize taxes,
and
Compared to sole proprietors, C Corporations also enjoy favorable tax rates:
15% on the first $50,000 of taxable income, 25% on the next $25,000 and a
graduated scale between 34-38% thereafter. In addition, corporations face far
less audit risk than sole proprietors.
Because a C Corporation is not a flow-through entity, it is taxed on its
profits, and you, if you receive dividends, are taxed on them as well on your
individual federal tax return. To work around this potential double taxation,
most solo and small C Corporations pay only salaries and fringe benefits, which
are then deductible to the corporation, and do not issue dividends.
Granted, it takes a bit of extra organization, paperwork and compliance to
establish and sustain a C Corporation; you must maintain separate books and
records, hold and record annual meetings and issue stock to shareholders. But
for those who seek maximum flexibility in fringe benefits and health care
options, a C Corporation offers many of the perks previously enjoyed only by
large corporations.
Not sure which business entity is right for you? Contact Traders Accounting
today. We can help guide you to the choice that best fits your needs, now and
into the future. Tax-wise planning starts from the ground up. Let Traders
Accounting help you build the right platform for your business today.
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- Well organized and very informative.
Ron Adams, Portland, OR
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