THE REASONS:
As a trader you need to form a separate trading entity for the following reasons:
  • 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 IRS scrutiny.
  • To allow Income Shifting or Income Splitting.
    • 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 your children.
  • 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 services.
  • 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 follows:
      • Form a corporation and immediately upon obtaining a federal id number using form SS-4, elect S-Corp status using form 2553 or...
      • Form an LLC and immediately upon obtaining a federal ID number using form SS-4, elect check-the-box corporate status using form 8832 and S-Corp status using form 2553.
        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 overstated.
      • 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 estate planning.
       
  • 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 form 8832.  In that case the SMLLC would be taxed as a C-Corp or if form 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:
       
      • There is little or nothing that a sole-proprietorship can't accomplish on its own in lieu of forming a SMLLC, other than offering some limited asset protection.
         
      • A SMLLC, is not a distinct and separate entity.  It is disregarded by the IRS as merely an Alter-Ego of its owner.
         
      • As the SMLLC is disregarded by the IRS - it is counter-intuitive to pay one's own self an earned income fee and therefore the IRS could retroactively disregard the transaction using the Alter-Ego theory to circumvent the creation of a sham transaction.
         
      • Even if the Alter-Ego theory was not invoked, paying one's self a fee does not create any "earned income" needed for medical deductions without completely ignoring IRS instructions for form 1040 schedule SE, IRC 1402(b) and Regs. 1.1402(a)-2(c).
         
      • It is just plain "penny wise and pound foolish" to use a SMLLC.  The use of other entity types (such as the multi-member LLC) does not carry with it the inherent risks of the SMLLC as used in this fashion.
         
      • Pound foolish? Because the IRS will recharacterize (eliminate) such transactions with your SMLLC under the theories of:
         
        • alter-ego theory
        • substance over form
        • step transaction doctrine
        • anti-abuse rules
        • self-charged rules
        • constructive receipt
        • sham transaction doctrine
        • substantial business purpose test
        • economic agreement test
        • binding commitment test
        • end-result test
        • interdependence test
        • "listed transaction" classification

        any one of which makes the risk of using a SMLLC a poor choice for a taxpayer and a choice that drives additional fees to tax advisors to defend you under examination.



      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 mark-to-market election.
     
  • 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 filed).
      • 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 satisfactorily complete.
      • 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.

ASSET PROTECTION:
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 separate entities.
  • Commingling of company funds and other assets.
    • not properly maintaining separate bank accounts for the entity.
  • Use of corporate assets for personal use.
    • using the entity's bank account "as the owner's personal checkbook."
  • Absence of any major corporate assets.
  • Unauthorized diversion of corporate assets.
    • failing to maintain a strong board of directors and maintaining minutes of their meetings.
    • using money for non-business purposes.
    • using money without authority as granted in the minutes or operating agreement.
  • Failure to maintain arms-length transactions.
    • 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 agreement.
    • 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 the corporation.
    • 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 of shares.
  • Use of the corporation for illegal or fraudulent transactions.
     
  • Meetings & Records:
    • Failure to have regular board of directors' meetings.
    • Failure to have annual shareholders' meetings.
    • Failure to have the required initial organizational meeting.
    • Failure to maintain up-to-date corporate records.
    • Failure to adopt corporate by-laws.
    • 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