As a trader you need to form a separate trading entity for the following
- To facilitate a so-called
"retroactive" mark-to-market election filing.
- To allow easy revocation of a
mark-to-market election, simply by stopping the use of the entity.
- To lower your risk of being
selected for IRS audit.
- The IRS has obsolete computer
systems, including magnetic tapes and 70 different operating systems.
With what little they have to work with, they must concentrate on the
individual form 1040, where most non-compliance issues are found.
- To lower your risk so that, if
selected for IRS audit, your trader status tax position will be more
likely to stand up against IRS attack.
- Business entities are assigned
to the more experienced field auditors who are savvy enough to
understand a business-person's perspective.
- Often, the tax form 1040 is
assigned to a less-experienced office audit examiner who starts off
assuming the taxpayer is guilty of some level of underpaying his taxes.
- To lower the chances of any issues
arising under the IRC §469 Passive Activity and Material Participation
Rules as concluded by the U.S. Supreme Court in Groetzinger.
- IRS Regs 1.469-1T(e)(6) state
that when a properly setup partnership or LLC is a trader, the §469
Passive Activity Rules for the most part do not apply to the owners.
- Corporations generally do not have
a form 1099 sent to the IRS reporting their activity. This lack of a 1099
matching program lowers the exposure of your corporation's tax return to
- To allow Income Shifting or Income
- If you had significant trading
gains this can allow you to shift a portion of that income from your
highest income tax brackets, for example to the lower tax brackets of
- Good way to allow you the ability
to create "earned income" and thereby make tax deductible retirement plan
contributions of $40,000+ each for yourself and for family members,
including young children.
- Keep in mind that "earned
income" is subject to
Social Security taxes of 15.3% on the first $87,900 (or so) per
year, per person and 2.9% on amounts over that.
- The "earned income" also allows
the possibility of deducting 100% of your family's health insurance.
- The "earned income" also allows
the possibility of deducting your family's medical & health expenses, if a
c-corporation is formed.
- To allow you to deduct a higher
meals expense allowance, if a c-corporation is formed.
- To lower or eliminate, to a
limited extent, the IRS and State taxes for any income allocated to an
out-of-State c-corporation (using a multi-entity set-up).
- The c-corporation tax rate is
15% on the first $50,000 of taxable income per year, limited to an
accumulation over several years of up to $250,000. Further subject
to any limitations applicable to personal holding companies (PHC).
- Be aware that an entity often has
higher fees charged by the brokerage and to obtain real-time quote
- Obtaining credit, opening a bank
account, opening a brokerage account, trading options and futures and
obtaining margin may entail more red-tape when working through an entity.
THE TYPES OF ENTITIES:
Some types of entities most popular with traders:
- Domestic Multi-Member Limited
Liability Company (LLC), taxed as a partnership
- This entity structure offers
great flexibility and versatility in allocating the taxable gains and
losses and operating expenses to the LLC members, to be taxed on the
members' own individual income tax returns. The LLC itself pays little
or no federal or State income tax. Special care must be taken so not to
inadvertently get trapped by Regs. §1.1402(a)-2(d) when aggregating
earned income for the year. LLCs may also offer some limited asset
protection against "charging orders."
- Owners (members) must number two
or more and may include, for example: husband, wife, child (caution if
less than two members are of legal age), other friend or relative, a
corporation, a LLC, an estate or a trust.
- You must maintain an Operating
Agreement, which at times can be cumbersome.
- Domestic S-Corporation
- When only one person is desired
to be the owner of the entity, an S-Corp has many of the same benefits
as does the Multi-Member LLC. The S-Corp is more tightly structured
than the LLC which for many purposes makes it particularly less
desirable than an LLC when there is more than one owner.
- On the other hand, an S-Corp
makes for a more bullet-proof assignment of a portion of the annual
trading gains into "earned income." The shareholder(s) are able to
receive W-2 wages which can clearly define the income to be used when
computing your retirement plan deduction.
- You elect to be an S-Corp as
- Form a corporation and
immediately upon obtaining a federal id number using
SS-4, elect S-Corp status using
form 2553 or...
- Form an LLC and immediately
upon obtaining a federal ID number using
SS-4, elect check-the-box corporate status using
form 8832 and S-Corp status using
update: new IRS Regs issued in July 2004
allow LLCs to forgo filing form 8832 and rather only file form 2553
under certain circumstances.
- You do not maintain an Operating
Agreement, as you would with an LLC, but you do need to maintain minutes
and by-laws. For many cumbersome items that would normally need to go
into an LLC Operating Agreement, the S-Corp may use an employment
agreement to make things easier to handle.
- Domestic or Out-of-State
C-Corporation as a member of your LLC or Limited Partnership
- When a member of your LLC is a
C-Corporation you can run your medical and health expenses through it as
a non-taxable employee benefit. Also you might qualify for a 100%
deductible IRC §119 mid-day meal deduction.
- Note that the C-Corporation is
a co-owner with you in yet another entity. Double the number of
entities and you double your fees and red-tape. Keep that in mind
before jumping into this style set-up.
- When a member of your LLC is an
Out-of-State C-Corporation, legitimately domiciled and operated in
Nevada for example, you can allocate a portion of your income to Nevada
where there is no State income tax and where the IRS would tax the gains
at the 15% tax rate.
- Note we said "legitimately
domiciled and operated." There are vendors out there mass-marketing a
"C-Corp solution" to taxpayers residing in high-tax States,
particularly to those living in California. We have seen many of
these setups were the taxpayer was charged thousands of dollars in
consulting, planning and incorporation fees where the benefits were
- You can not trade from
California through a registered Nevada C-Corp and legally avoid all
California State taxes - due to the concept of taxation called "nexus"
(for more information, search for "nexus" on this page: A Trader's
Choice of Entities )
- You can allocate a reasonable
portion of your income to Nevada, if you properly structure and
segregate the business activities of each entity. But unless you
change your State of residence to Nevada, and perform your work in
Nevada, then you will not legally be able to allocate all of your
income to Nevada.
- We feel that for most traders
this is too costly and has extra red tape that out weighs the
potential tax savings - but there are many profitable traders who do
have this type of multiple-entity set-up.
- Family General Partnership (FGP)
- Less formal, easy and less
expensive to form and offering many of the same features as an LLC taxed
as a partnership.
- We recently saw a newsletter
sent to traders mentioning this concept with a husband & wife JTWROS
account as their so-called new "idea." But bear in mind that family
partnerships have been around for a long time. We have been putting
clients into family partnerships including husband/wife partnerships,
the correct way, for decades.
- The concept of bona-fide family
partnerships has been mentioned for free on this web site since it was
first established in 1999, after the "new entity rule" was established
by Rev Proc 99-17. So this can hardly be thought of as a new "idea" for
traders today - but be aware that experience has shown that when the
owners are solely a husband and wife care must be taken to qualify under
IRC Code §6231(a) and §761. The mere co-ownership of assets does not
qualify under scrutiny. Regs. §§1.761-1(a), 301.7701-1(a)(2). While we
have been doing bona-fide family partnership for traders since 1999 and
for other taxpayers for many, many years prior to that, this is not
necessarily preferable to the other entity structures listed above.
- Regardless, it is inappropriate
to flaunt something implying that it is somehow an underhanded
tax-motivated scheme. Substance over form and taxpayer intent go a long
way in establishing credibility with the IRS. In all cases, the family
partnership must be a bona-fide economic, business-like arrangement.
These should be handled on a one-on-one basis, not some mass-marketing
cookie cutter approach that is sure to peak the interest of the IRS once
they think they smell a tax cheat.
- You may optionally choose to
maintain a Partnership Agreement.
- Family Limited Partnership (FLP)
- More formal, difficult and more
expensive to form than a LLC or a FGP. These have similar tax attributes
with added features that are useful for asset protection plans and
family gifting estate plans.
- Usually used by wealthy, solidly
successful, somewhat more mature traders with children as part of their
- Domestic or Out-of-State
Single-Member Limited Liability Company (SMLLC)
- A SMLLC may be owned, for
example, by one individual, by one LLC or by one corporation.
- This specialized entity might be
used for asset protection, SEC rule work-arounds, to definitively
segregate some trading activity from other activities and for other
purposes that need a separate legal entity for non-tax purposes. The
SMLLC is disregarded by the IRS for tax purposes unless it files the
appropriate election to not be a disregarded entity on
8832. In that case the SMLLC would be taxed as a C-Corp or if
2553 is also filed, as an S-Corp.
- If form 8832 is not filed the
entity generally is disregarded for all tax purposes and elections as an
entity separate from its owner. It is treated under the IRS regulations
as a "Alter-Ego entity." Alter-Ego theory also allows the IRS to undo
many "creative" but ineffectively designed tax-motivated schemes using
corporations, trusts or SMLLCs.
- Even if disregarded, a SMLLC
owned by an individual (rather than by an entity) may create earned
income for a trader's spouse by paying a salary or fee for services
rendered by the spouse. Of course a similar result could be accomplished
without bother of using a SMLLC as well (since a SMLLC is disregarded by
the IRS anyway).
- We have received many inquiries
recently regarding the use of SMLLCs to allow mark-to-market elections
and to create earned income for its owner allowing: retirement plan
contributions and medical deductions. SMLLCs should not be used for
these purposes because:
Other entities that are disregarded as taxable entities from their
owners including: Qualified Real Estate Investment Trust Subsidiaries (QRSs),
Qualified Subchapter S Subsidiaries (QSubs) and Single Owner Eligible
Entities should be avoided for trader status strategies.
Under §301.7701-3(b)(1) and (2), an eligible entity with a single owner
may be disregarded as an entity separate from its owner. Section
301.7701-3(b)(1)(ii) provides that a domestic eligible entity with a
single owner is disregarded unless the entity makes an election to be
classified as an association (and thus a corporation under
§301.7701-2(b)(2)). Section 301.7701-3(b)(2)(C) provides that a foreign
eligible entity with a single owner that does not have limited liability
is disregarded unless the entity elects to be classified as a
corporation. Under §301.7701-3(c), a single owner eligible entity that
has elected to be treated as a corporation and a foreign eligible entity
with a single owner that has limited liability (that would otherwise be
treated as a corporation under §301.7701-3(b)(2)(i)(B)) may elect,
subject to certain limitations, to be disregarded.
BEFORE USING AN ENTITY:
Most traders start out as individual sole proprietorships (form 1040
Schedule C). Some observations regarding Schedule C:
- If mark-to-market is desired,
generally you must notify IRS that you elect in advance of filing your tax
return - sent via certified mail between the dates of January 1 and April
15 of the year that mark-to-market is to begin.
- This is more cumbersome than a
separate newly formed entity which elects mark-to-market when it is
formed or when operations begin, but does not actually notify IRS until
its first separate tax return is filed.
- Note that SMLLCs generally do
not file their own separate tax returns, therefore making a retroactive
election under the guise of a newly formed SMLLC is foolhardy at best.
- Mark-to-market is a permanent
election. To drop the election you need to secure the written permission
from the IRS Commissioner. It is not clear if mere changing or closing
the trading business or trading account has any ability to revoke the
- IRS audits are primarily targeted
at individuals (form 1040), and among individuals they are more
specifically targeted at those filing Schedule C and showing a loss.
- Traders, by definition, show a
loss on Schedule C. That's where your expenses are deducted, whereas
your trading gains are reported on Schedule D or Form 4797.
- It is improper for a trader to
reclassify any portion of interest income, dividend income, trading
gains or losses from Schedule B, Schedule D or Form 4797 to Schedule C
to obfuscate the Schedule C loss. By law, only a Securities Dealer is
allowed (is required) to report gains and losses on Schedule C.
- Taking this improper position
could result in an underpayment or overpayment of tax, but often this
is not too serious an amount for IRS and State tax purposes - though
it can occasionally have significant implications.
- Taking this position to
obscure the proper reporting of your deductions can be a violation of
IRS procedures subject to penalty (unless form 8275 or 8275-R is
- While the odds are with you
against getting caught in a random audit and penalized for taking this
kind of position, if you are selected for audit you run the risk of
being pegged as an uncooperative adversary at worst or a poor tax
preparer at best, making the audit itself more difficult to
- To date, over 50% of the IRS
audits we've handled here (of tax returns that were initially prepared
elsewhere) have been triggered specifically because the preparer
reported some portion of trading gains and losses on Schedule C, and
the IRS then sent the tax return to an agent/examiner to investigate.
- Individuals selected for audit
typically find their position of trader status under scrutiny.
- If the trader also has W-2
wages, the standard line from the IRS is that that is your gainful
employment and that the trading is merely an investment activity.
- If the trader has significant
investment income, the standard line form the IRS is that your trading
is merely more of the same investment activity.
- If the trader has investment
income generally a portion of his expenses need to be allocated between
trading and investing. Expenses allocated to investing are generally
limited in their usefulness.
Breaking the corporate shield:
Courts have identified a fair number of instances where they will "pierce
the veil" and hold the officers, shareholders or members personally liable
and/or attach company and personal assets. (for clarity the words corporate,
company and entity are used interchangeably in this list):
- Failure to segregate funds of
- Commingling of company funds and
- not properly maintaining
separate bank accounts for the entity.
- Use of corporate assets for
- using the entity's bank account
"as the owner's personal checkbook."
- Absence of any major corporate
- Unauthorized diversion of
- failing to maintain a strong
board of directors and maintaining minutes of their meetings.
- using money for non-business
- using money without authority as
granted in the minutes or operating agreement.
- Failure to maintain arms-length
- transactions with owners treated
more preferentially than might be with 3rd parties.
- failing to authorize loans or
advances between entity and owners in the minutes or operating
- failing to maintain written
interest bearing loan agreements.
- failing to charge and pay
adequate interest on loans and advances.
- failure to make appropriate
periodic payments of interest and principal.
- failure to pay appropriately
competitive wages to the owners.
- Failure to adequately capitalize
- Failure to transfer some assets
into the corporation. i.e.Underfunding the corporation
- failure to issue corporate stock
or maintain corporate ledger.
- failure to actually pay for your
common stock or interest in the entity.
- Unauthorized issue or subscription
- Use of the corporation for illegal
or fraudulent transactions.
- Meetings & Records:
- Failure to have regular board of
- Failure to have annual
- Failure to have the required
initial organizational meeting.
- Failure to maintain up-to-date
- Failure to adopt corporate
- Failure to get the proper state
and local business licenses in the name of the corporation.
- Taxes & Fees:
- Failure to pay taxes,
particularly "trustee" (payroll) taxes.
- Failure to pay required
Secretary of the State fees.
- Failure to file required
(annual) Secretary of the State forms and fees.
- Failure to advertise and serve
notice that the business was operating as a corporation i.e. holding
yourself out as a corporation ( letterheads, etc. and always sign
documents as the corporate officer, not just personally )
On March 2, 2004 the US Supreme Court decided Yates. Dr. Yates had a
corporation with employees in addition to himself and his spouse and as such
under ERISA was able to protect his profit sharing plan from creditors.
On April 4, 2003 the United States
Bankruptcy Court decided
Albright. Ms. Albright had a single-member LLC plan that was unable to
protect assets from creditors. This has not effect on liability shields