There are many benefits to forming a separate legal entity to house your trading business. First and foremost, having a separate legal business entity shows that you are serious about your trading business and have gone through the trouble and expense of forming a business entity. Filing a separate business entity tax return each year also demonstrates that you have attempted to be a real, bonafide trading business. Setting up a business entity for your trading business won't by itself be sufficient to win you trader status with the IRS. However, for those part-time traders on the fence, forming a business entity may provide additional evidence to the IRS in an audit that you have an active trading business.
By forming a business entity and establishing yourself as a qualifying active trader, you are able to convert many "below-the-line" investor deductions to "above-the-line" business trader deductions. These business trader deductions are reported on your business trader tax return which in most cases will flow through to your personal tax return via a Schedule K-1 (S corp or partnership).
Another major benefit to forming a separate business entity includes being able to take advantage of the Mark-to-Market trader status in the year in which the entity was formed rather than having to wait a year like a sole proprietor. Nobody ever plans to have losses but having the ability to deduct 100% of your trading losses in the year you formed your business is a big deal. Since every new business entity must establish their method of accounting within 75 days of formation, the procedure for electing MTM accounting is quite simple. Simply document in your corporate minutes, by-laws, LLC operating agreement or partnership agreement that the MTM accounting method was elected and indicate this method of accounting on your current year's tax return. We also recommend adding detailed footnotes to your tax return claiming your active trader status and MTM accounting method.
Having a separate legal entity allows traders to generate earned income which is needed in order to contribute to a retirement plan. In most cases, a sole proprietor is not able to create earned income and thus not able to contribute to a retirement plan. With a separate business entity, management or administrative fees can be paid to the owner in the form of guaranteed payments (partnership or LLC), or salaries (corporation or LLC). These management fees create the earned income needed so that a trader qualifies to make retirement plan contributions. We've discussed this benefit in further detail below as well as in the Retirement section of our site. Business entities are also entitled to other tax-deferred or tax-deductible employee benefit plans but their owners are not. You can hire your spouse and possibly your kids but proceed with extreme caution.
The other major benefit of having a separate legal entity such as a corporation or limited liability company is the limited liability protection. A separate business entity such as a corporation or LLC is legally independent from its owners who are not generally liable for the debts, obligations and liabilities of the entity.
We want to continue to stress that in addition to forming a business entity, you still need to meet the IRS trader tests discussed in the Pro Trader section of the site. However, for part-time traders trying to qualify as an active trader, forming a business entity may be just enough to tilt the scales in their favor with the IRS.
There is no one best entity for day traders. Each has its advantages and disadvantages. We have outlined a few of the more commonly used structures below, but choosing which entity is best for you will depend on several factors such as ease of creation, liability of the owners, tax considerations, and the need for capital. To find the entity best suited for your individual situation, contact a qualified trader tax specialist who can evaluate your specific needs.
Multi-Member Limited Liability Company
Limited Liability Companies (LLC) are another type of entity that can work well for traders, especially for husband and wife trading businesses, or in situations where outside investors are needed. A limited liability company, commonly called an LLC, is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. It combines the best features of the partnership and corporate business structures.
Like owners of a partnership, owners of LLCs (members) usually report the income or loss from the LLC on their personal tax returns. LLC’s that have several owners are multi-member LLCs and are generally taxed like partnerships. It is important to note that a LLC is not a separate taxable entity and does not pay federal and state income taxes. However, some states, such as New York, do levy annual filing fees on LLCs.
Like owners of a corporation, all LLC members are protected from personal liability for business debts and claims, a feature known as "limited liability." This means that if the business owes money or faces a lawsuit; only the assets of the business itself are at risk. Creditors usually cannot reach the personal assets of the LLC members, such as an individual’s house or car. However, both LLC owners and corporate shareholders can lose this protection by acting illegally, unethically, or irresponsibly.
The owners of most small LLCs participate equally in the management of their business. This arrangement is called member management. There is an alternative management structure called manager management, in which the LLC designates one or more owners (or even an outsider) to take responsibility for managing the LLC. The non-managing owners (sometimes-family members who have invested in the company) simply sit back and share in LLC profits. In a manager-managed LLC, only the named managers get to vote on management decisions and act as agents of the LLC. Choosing manager management sometimes makes sense, but it might require you to deal with state and federal laws regulating the sale of securities.
The LLC is unique in that members, not shareholders, draw up an operating agreement to run the business without the structural guidelines imposed on a corporation. There is no need to meet the requirements and formalities of a corporation, such as Board of Director meetings, to maintain the business status. Members can draw up their own contract, allowing for flexibility in management and responsibilities. LLCs also have greater flexibility than corporations in allocating income to members. For example, an LLC can have various classes of interest, while an S corporation can issue only one type of stock.
Single Member LLC
A single member LLC (SMLLC) is as the name suggests a limited liability company that has only one member. SMLLCs are permitted in all fifty states including the District of Columbia. The SMLLC, under current IRS rules, is disregarded for federal income tax purposes (unless it elects to be treated as a corporation). If the only member of the SMLLC is an individual; the taxpayer can file a Form 1040 and attach the necessary supporting forms. For example, all trading expenses would be reported on Schedule C (Profit/Loss From Business), MTM trading gains and losses reported on Form 4797 (Sale of Business Property – Part II Ordinary Gain/Loss), and interest and dividend income on Schedule B (Interest and Dividends).
SMLLCs have become popular in recent years, and many traders are attracted to this form of tax reporting. There are two main differences between the SMLLC and the sole-proprietorship. First, the taxpayer secures a tax identification number (EIN) for the LLC, which is used on the Schedule C, in place of the taxpayer’s social security number (SSN). Secondly, the LLC is allowed to pay the owner a fee to generate earned income.
The potential tax benefits come from the administrator of the LLC’s ability to file a second Schedule C. The second Schedule C reports a fee from the LLC’s trading business, which is the filer of the first Schedule C. This reporting creates a wash and results in no significant difference in income, with the first Schedule C withholding an amount equal to what the second Schedule C reported as income. The tax benefit comes from the second Schedule C showing earned income, which opens the door for the SMLLC owner to reap the rewards of retirement planning, health premium deductions, and income tax savings in excess of self-employment taxes.
There are some pitfalls to operating a SMLLC. The IRS has taken the fall back position that the SMLLC is, for tax purposes, considered to be a sole proprietor, or a disregarded entity. Unfortunately, this may put the trader right back in the position of being viewed as a sole proprietor without any of the afforded benefits or protections. This is one of the two main problems with using a single member LLC for your trading business, and why we dont recommend SMLLCs
One of the primary reasons to form a limited liability company is to shield its members from the debts and obligations of the company. Legally formed and operated properly, the LLC should protect members – or in the case of a SMLLC its member -- from the company's financial problems. However, if asset protection is one of your principal goals then a SMLLC may not be the right entity for you, as it does little for asset protection.
In the bankruptcy case of In re Albright, the debtor initially filed a Chapter 13, which was later converted into a Chapter 7 liquidation. The debtor was the sole member and manager of a SMLLC, which was listed as one of the assets of the bankruptcy estate. The trustee filed a motion to permit the trustee to liquidate the SMLLC and its assets.
The trustee argued that because the debtor was the sole member and manager of the SMLLC at the time she filed bankruptcy that the Chapter 7 trustee, had in essence, stepped into the role of the debtor. Therefore, the trustee had become the "substituted" sole member of the LLC and, as such, could employ new managers and/or vote to liquidate the LLC in its entirety. The Court agreed and assigned the debtors complete interest in the SMLLC over to the bankruptcy trustee, who then liquidated the LLC’s assets.
The Court conceded that the result would have been different, if there had been other non-debtor members in the debtor’s LLC. "Where a single member files bankruptcy while the other members of a multi-member LLC do not, and where the non-debtor members do not consent to a substitute member status for a member interest transferee, the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled."[i]
The court In re Albright issued a warning to those attempting to sidestep the single-member bankruptcy issue by simply adding a second member to their LLC. “To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with ‘peppercorn’ co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse.”
In recent years, there have been similar cases involving bankruptcies and SMLLCs.[ii] In those cases, the Court agreed that the bankruptcy trustee succeeds all management rights of the LLC, and that the trustee has the right to exercise management powers over the LLCs. They can dissolve the LLC and distribute its assets to the bankruptcy estate, thus making assets available to pay creditors. When this occurs, the bankrupt member is left with zero asset protection. This is the second major problem with single member LLCs, and why we don't recommend them to our clients.
The corporation has been in existence longer than any other form of legal entity. Corporations enjoy several tax deductions and “perks” that are unavailable to partnerships and sole proprietorships. Traders interested in forming a corporation can elect to create either a regular (called “C”) or an S corporation. As both the C and S corporation provide the same level of asset protection in terms of personal liability protection, the main distinction is in how the corporation and its owners are taxed.
Incorporation by default makes the business entity a C corporation, which is considered a separate taxpayer. Corporations can work well as a trading entity, but great care must be taken to structure it properly from a tax standpoint. A C corporation must report its income and expenses on a Form 1120, U.S. Corporation Income Tax Return. The taxable income will be the money the corporation retains at the end of the year for its future needs and operating expenses, and the amount it distributes to its shareholders as dividends. Under a C corporation, the owners are only required to report compensation and other taxable amounts received from the business, on their individual tax returns.
For some business owners, the corporate tax rate will be lower than their personal marginal tax rate, and they may thus obtain a benefit from having the corporation retain profits taxed at the lower rate. Another benefit of C corporations is the use of fringe benefit plans. C corporations enjoy the most tax-favored fringe benefits of any form of entity, such as retirement and medical plans. Unlike owners in partnerships, S-corporations and sole proprietorships, shareholder-employees of C corporations are able to participate in fringe benefit plans such as Sec. 125, flexible spending plans and have their medical insurance premiums fully deducted at the corporation level.
One of the disadvantages of a C corporation is that it is only allowed to take capital losses to the extent of capital gains. Unused capital losses can only be carried back for three years and forward for up to five years. However, a trader that forms a C corporation and qualifies for MTM trader status will not have its trading losses subject to this capital loss restriction. Another disadvantage of corporations in general is that they typically require more ongoing paperwork than most other business entities in order to stay compliant with the law and maintain their corporate status. This includes holding and documenting annual meetings of shareholders and directors and keeping minutes of important corporate meetings.
Another disadvantage of C corporations is the potential for double taxation. Double taxation occurs because corporations are considered separate legal entities from their shareholders. As such, corporations pay taxes on their annual earnings, just as individuals do. If those earnings are distributed to a shareholder, this distribution is treated as a dividend, which is then taxable to the shareholder. The effect of this is that corporate earnings are taxed twice—once at the corporate level and once at the shareholder level, when the earnings are distributed in the form of dividends. The way corporations are taxed provides some interesting and challenging planning decisions.
The problem of double taxation may be eliminated in one of two ways. First, the corporation can pay out as salary an amount equal to its net earnings. This is called zeroing out the corporation. As an example, a medical corporation might have a profit of $100,000. If this amount is paid to one or more of the officers of the corporation as compensation for services, the corporation will get a tax deduction for this $100,000 in salary. That will reduce taxable income to zero, and no federal income taxes would be due. The $100,000 is included in income, and the recipient pays the tax. This eliminates the problem of double taxation.
The IRC imposes certain limitations on this technique by allowing a deduction to the corporation, only if the amount of compensation paid to a particular individual is "reasonable." The salary cannot be excessive based upon the actual services provided by the individual. There have been thousands of cases litigated by the IRS on this issue, and no firm rule has developed. If the salary is comparable to that received by others in similar businesses, it is unlikely that there will be a challenge from the IRS.
If you attempt to pay salary to your children or your grandmother without any services performed by them, the deduction could be disallowed as unreasonable. If the salary is disallowed as unreasonable, this amount is added back to the corporation’s income and a tax is assessed on this income. In addition, the amount that was distributed is treated as a dividend to the recipient and is taxable to that individual. This produces a double tax on the same income and is clearly a disastrous result.
Dividends are paid to shareholders/owners from the after-tax profits of a C corporation. The dividends received by the owners are then taxed personally on dividends received. This means the income is taxed twice, if dividends are paid. The good news is that since the Tax Relief Act of 2003, dividends have received preferential tax treatment. They are taxed at the lower capital gains rate.
As mentioned earlier, shareholders of corporations can elect to obtain S corporation status, which would allow them to report business income and expenses on their personal returns. Like a partnership, income, losses and other tax items pass through the corporation to the shareholder for reporting on one’s personal income tax return. The corporation does not pay tax.
If you decide to choose S corporation status, you will need to make the federal election by filing Form 2553, Election by a Small Business Corporation (also check with your state to see if you are required to file a separate document for income tax purposes). You can elect to form an S corporation as soon as your business is incorporated. The IRS does not charge a fee for making the election.
S corporations work well for trading entities that only have one shareholder. These corporations must allocate income and loss based on their proportionate share of ownership equity. The income or loss generated in the business flows through to the trader-shareholder’s individual income tax return. Shareholders that are active in the business are required to pay him or herself a salary during the year. This requires a bit more administrative work than most traders want to do, as calculating the proper tax withholdings, and preparing and filing quarterly payroll tax returns and year-end W-2s. Finding a full-service accounting firm or payroll company to provide this function is critical. A benefit from paying yourself a salary is that you create earned income and are able to set up a corporate retirement plan.
Because the taxation of income to sole proprietorships and partnerships is determined by the tax bracket that applies to each individual owner, a comparison of tax rates that apply to corporations and to individuals can give you some idea of which form of business would save taxes at a particular income level.
The following chart compares the marginal tax rates for tax years beginning in 2009 for corporations, married individuals filing jointly, and for singles.
Note: personal service corporations (those whose employees spend at least 95 percent of their time in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) are taxed at a flat rate of 35 percent of net profits.
As the table shows, corporations generally have the same, or a higher tax rate imposed on their income compared to those subject to individual tax rates. Also, keep in mind that the rate comparison is only part of the tax picture to consider. Distributions (money taken out) from a partnership are generally taxable only once on the partners' individual returns, while distributions made by a corporation to its shareholders after corporate tax is paid are taxed again as dividends on the shareholder's returns.
In comparing the tax advantages of operating as a partnership or sole proprietorship rather than as a corporation, remember that not all of the corporate profits will be subject to double taxation. The operators of the corporation may withdraw reasonable salaries, which are deductible by the corporation. These salaries are therefore free from tax at the corporate level (though the recipients will have to pay income tax, and both recipients and the business will have to pay FICA tax, on them). In some cases, salaries to the owners may offset the entire net profit, so that no corporate income tax is due.
Like individuals, corporations can become subject to an Alternative Minimum Tax (AMT), if they have gained the benefit of "too many" tax preference items. As of 2008, the corporate AMT will not apply to any corporation if:
General Partnership - spousal
Putting your trading business in a general partnership with your spouse often makes a lot of sense for personal, business and tax reasons. Often times, a portion of the trading capital comes from the spouse. So from an estate perspective, it is important to have the spouse as part of the trading business. There are also several tax advantages to doing it this way. But be sure to list your spouse on the brokerage statements if you do not have a separate business name for your partnership. It is also important that your spouse places a role in the business, whether it is bookkeeper, researcher, trader or manager. Trading partnerships seem to be exempt from the passive activity rules as far as their MTM losses are concerned but their trading expenses are another matter and are still subject to the PAL limitations. Therefore, make sure your spouse is active in the business in some capacity.
A partnership is a flow-through entity meaning that the taxable income or loss first gets reported on a partnership return and then winds up on a taxpayer's personal tax return. Entities that would normally be considered a partnership may elect to not be treated as partnerships for income tax purposes if the income of the partners can be determined without computing the entity's income first or in the case of certain husband-wife partnerships. In the case of a husband and wife trading business, the income and expenses can either be reported on Form 1065 (partnership rerturn) or on two Schedule C's (sole proprietor) on Form 1040 (individual tax return). In either case, the income and expenses are reported on the personal tax return and effect ones individual taxes.
A limited partnership is an entity that is used primarily to raise money from passive investors, who become the “limited partners” of the entity. This type of entity works well for traders that want to raise trading capital from outside investors. Limited partners do not participate in the management or operations, and they are not responsible for the debts and civil claims of the limited partnership beyond their investment in the business. A limited partnership must have at least one “general partner”, and at least one “limited partner”. The general partner(s) manages the day-to-day operations of the partnership. Each general partner in a limited partnership is personally liable for all of the debts and obligations of the business, including civil claims against the partnership. Because of this liability exposure, often the general partner is a corporation.
A limited partnership is also a good vehicle to use when including family members in a trading business. With active trader status, a limited partnership allows the general partner to control the trading activity yet distribute tax benefits, including ordinary loss treatment, to its investors. Because of a “quirk” in the trader tax laws, passive investors in a trading business are exempt from the passive activity loss rules.
In other words, passive investors get to enjoy all of the tax benefits that an active MTM trader enjoys, including full deductibility of ordinary losses and full deductibility of trading business expenses. The MTM election is made at the entity level and any trading losses pass through to all partners. The one deductibility limitation for passive investors is that they are only able to deduct investment interest expense up to the amount of their investment income. This passive loss loophole for traders is discussed again later in this chapter.
Although limited partnerships are required to file annual tax returns, like general partnerships, they do not pay federal and state income taxes because the profits and losses of the business pass through to the individual partners. Profits and losses in a partnership may be allocated unequally among partners, without regard to proportionate ownership interests, to take advantage of tax benefits.
Partnership tax rules are some of the most complicated sections of the Code and regulations, but provide a great deal of flexibility when structuring a partnership agreement. When drafting a limited partnership agreement, be sure to work with a qualified and experienced tax advisor.