The rise of online and discount brokerages is making people interested in trading and the stock market. However, taking advantage of the various strategies on asset protection and tax advantages that are available to companies is impossible for individuals or sole proprietor traders. Market trading can be a source of extra income or can be a full-time job. The generated income from trading is also taxable just like any businesses and successful traders can make significant tax liabilities.
A person can individually trade or be a sole proprietor, can also qualify for a trader status or can also trade through a business entity. It is often the best asset protection as well as the best tax treatment to create a legal trading business.
Trading is not considered a business activity according to the IRS. As a matter of fact, all generated income from trading is counted as passive income or unearned. Any individual that will not qualify for a trader status will be treated as tax filing individual since the presumption is a person is an investor and any trading activity is not done for paying current liabilities for long-term capital accumulation.
By just paying the IRA or pension, the generated income from trading will not be reduced. The only benefit you can get for being a passive trader is that the income generated from trading does not subject to extra self-employment taxes. Subsequently, the deductions will be the same as with the W-2 wage earners. This is commonly limited to property taxes, mortgage interest, and charitable deductions. Most of the amount of the deduction is limited to a percentage of adjusted gross income. Since trading is not regarded as a business activity, all of the necessary expenses in trading are not included as deductions. The necessity cost for most traders that are active can be considerable. These include a trading platform, education, software, computers, internet access and the like.
The biggest tax issue for most traders is that the trading losses deductions are limited to gains. Only 3,000 dollars can be deducted after that against ordinary income. When the losses in net capital exceed 3000 dollars, a person can only carry forward an annual loss of 3000 dollars against future income.
Qualifying for trader status is one solution of some active traders just so they can avoid such tax treatment. Filing a Schedule C is allowed to qualified traders. They can then deduct necessary and ordinary business expenses including margin interest, entertainment, education, and other expenses related to trading. Section 179 deduction can also be taken by qualified traders and for equipment used in activities in trading, they can write off up to 19,000 dollars a year. Lastly, Section 475(f) can be elected by a qualified trader or the Mark to Market (MTM) election.
Traders are allowed to change into ordinary income and lose their capital gains and losses because of the mark-to-market accounting which started in the late 1990s. A hypothetical gain or loss is computed on the last day of the year since it is assumed that all positions are to be sold at market value. It is also assumed that all positions are purchased at market value on the following year which will be the basis for the calculation. Just for the purpose of tax, the hypothetical gains and losses are added to actual gains and losses at year-end.
All losses are subtracted in the year they occur since under MTM, gains, and losses are considered as ordinary income. Traders, under MTM, are not bound by the 3000 dollar restriction on net capital loss and they can subtract all losses in the year it occurs, providing the full tax relief in the present year. There are traders that will elect MTM to be able to evade the 30-day wash sale rule, which prohibits loss deductions on significantly similar securities obtained within 30 days before or after a sale.
General guidelines to qualify to trade as a business are covered in the IRS Publication 550 and Revenue Procedure 99-17. For a trader to be considered as business, the trading activity must be full-time and the income is generated through day trading. A trader, according to the IRS, is a person who significantly trades and continuously gain from the short-term fluctuations in security prices.
A person who makes several trades daily to gain from intraday market fluctuations and perform continuously all throughout the year is a trader. A lot of time, effort, and money are spent on researching and documenting trades and strategies to conduct the business. Although not exactly required, a lot of trader’s open and closes multiple trades every day and keep their positions not more than 30 days.
For active traders, the advantage of being eligible is clear, but these rules are to be interpreted by the IRS and the courts.
To ensure that you are getting the same tax treatment as a qualified trader is to create a limited liability company (LLC) or limited partnership. Usually, the legal entity gets not so much scrutiny by the IRS since it is assumed that no one would want to go through the dilemma of forming the entity unless they opted to have trading as a business venture. Changing the accounting method is extremely difficult for individuals once it has been closed. If changing is necessary, it is better to dissolve an entity and re-formed it accordingly.
For traders who are very successful, many advisors will recommend structures that consist of several entities to make the most of the tax and protection benefits. Although the real structure is defined by the person’s financial goals, it commonly consists of a C corporation, which happens to be the managing member of the general partner of various limited liability companies. In this manner, additional income can be assigned to the corporate entity over an agreed management fee to make the most of the additional tax strategies available.
For instance, to give your child tax-free money or to sponsor college expenses, you can appoint your family members to become your employees. While making Medicare and Social Security accounts, the corporation can take advantage of deductible education expenses and salaries. Medical Compensation plans can be formed to subsidize all forms of elective health care and medical insurance premium. Your accounts for retirement, IRAs and 401(k)s for instance, can be assigned into a 401a. A 401a is an ERISA pension fund that can in no way be affected by creditors or by a legal claim. Since the corporation compensates taxes on net income, the target is to compensate as many expenses as possible with pretax dollars and to reduce the taxable income.
This form of business structure also offers excellent protection to your assets since it separates from the individual businesses. Other limited liability companies can retain long-term assets. They can use accounting methods that are better for investments. All assets are guarded from the individual’s legal liabilities as well as from the creditors since they are considered as separate legal entities. The state law determines the amount of legal protection needed. It is suggested by most of the advisors to form entities in the states where piercing of the legal structure is not allowed. Nevada is mostly preferred in forming entities since it lacks corporate sales tax, the secrecy of not having to record shareholders, adaptability in changing orders as a sole remedy by creditors, and the nomination of corporate officers.
It is always best to seek advice from those who understand the operation and formation of trading activity to be able to get the best tax treatment and legal protection.
MPS Tax