People these days are trading the stock market in an ever-increasing number with the proliferation of online and discount brokerages. However, the many tax advantages and asset protection strategies available to companies cannot be taken advantage of by the traders as an individual or sole proprietor. Market trading can possibly be a full-time living or just a way to make extra income. For the successful trader, the income generated from trading is taxable and can create significant tax liabilities like any business. Trading as individuals or sole proprietors is possible to an individual and also qualifying for trader status, or trading through a business entity are possible too.
Trading is not a business activity according to the IRS. Unearned or passive is what the trading income considered as. A presumption that long-term capital accumulation is what a trading activity is and not for paying current liabilities and individuals are considered investors. For this reason, an individual will be treated like any other tax filing individual unless he or she can qualify for trader status.
Contributing to an IRA or pension cannot reduce a trading income. The income derived from trading is not subject to additional self-employment taxes -- that is the only advantage of being considered as a passive trader. After that, they will have deductions that are generally limited to mortgage interest, property taxes and charitable deduction which are normally afforded to W-2 wage earners. Most deducted amounts are restricted to a percentage of adjusted gross income. All the expenses necessary to trade are excluded as deductions because trading is not considered a business activity. The cost of necessities such as a trading platform, education, software, internet access, computers and the like can be considered for most active traders.
Deductions for trading losses are limited to gains is the biggest tax issue most traders face. Only $3,000 can be deducted against ordinary income after that. Individuals can only carry forward $3,000 of that loss per year against future income if in a year net capital losses exceed $3,000.
Some active traders try to qualify for trader status to avoid such tax treatment. Filing a Schedule C and deduct ordinary and necessary business expenses are allowed for qualified traders. Writing off up to $19,000 a year for equipment used in trading activities on Section 179 deduction is also possible for qualified traders. Finally, electing a Section 475(f) or the mark to market (MTM) election can be done by a qualified trader too.
Changing the traders' capital gains and losses to ordinary income and losses have been allowed in mark-to-market accounting since the late 1990s. A hypothetical gain or loss is calculated after all positions are assumed to be sold at market value on the last day of the year. Calculated by assuming these positions were also purchased at market value is the basis for each of these positions for the following year. For tax purposes, in the actual gains and losses, the hypothetical gains and losses at year-end are added.
The IRS has set out general guidelines in IRS Publication 550 and Revenue Procedure 99-17 -- this provides guidance as to the activities that qualify to trade as a business. A person must trade on a full-time basis and derive most of his or her income through a day trading to be engaged in business as a trader in securities. Someone who continuously and significantly trades to profit from the short-term fluctuations in security prices is a trader according to the IRS.
Individuals who continuously make multiple trades daily to profit from intraday market swings throughout the year are traders. They incur a significant amount of expenses to conduct their business and they also spend a considerable amount of time documenting and researching strategies and trades. Most qualified traders will open and close multiple trades daily and hold their positions for then than 30 days although it is not specifically required.
These guidelines are somewhat open to interpretation by the IRS and the courts though the benefits of qualifying for active traders are obvious. Even for some whose only income is derived through trading, only a small percentage qualify.
Creating a separate corporate entity to trade through is the only way to ensure that you will receive the same tax treatment as a qualified trader. You can receive all the same tax treatment as a qualified trader without having to qualify by creating a limited liability company (LLC) or limited partnership. The IRS has an assumption that no one would go through the trouble and expense of forming the entity unless they were committed to trading as a business venture that's why the legal entity usually receives less scrutiny from the IRS. Once the election has been chosen such as MTM, it would be extremely difficult for an individual to change it. There is an advantage with the company to change accounting methods or legal structures.
Trading can also add a significant amount of complexity to one's personal affairs although it has some obvious benefits. But, it is better to speak with a professional advisor who understands the operation and formation of these entities for traders to receive the best tax treatment and legal protection.
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