Tax Tips For Traders
For the successful trader, the best tax advice is to incorporate.
With the proliferation of online stock and option trading, traders are looking for tax advice on the best way to structure their trading business. This especially true for day traders, those people that produce most or all of their income from trading. An individual or sole proprietor cannot take advantage of the numerous tax advantages and asset protection strategies available to companies. In order to gain the same tax treatment afforded to companies, traders are incorporating their trading businesses.
Tax Treatment for Companies
Trading through a business structure is good tax advice since all the activities of a company is tax deductible. Individuals earn income, pay taxes on that income, and then spend what is left over. Companies, on the other hand, earn income, spend that income, and pay taxes on what is left over. The key tax tip for trader is to incorporate and to take advantage of all the tax exemptions afforded to companies.
According to the IRS, "trading" is not a business activity. It considers all income from trading as unearned or passive income. The presumption is that the trading activity of individuals is done for the purpose of long-term capital appreciation and not for paying current liabilities. In this situation, unless an individual can achieve trader status, they are treated as long-term investors by the IRS. Achieving trader status is difficult and is not just based on the amount of money produced by trading or the number of trades made daily. Regardless of how frequent they trade, most individuals and day traders will not achieve trader status and be considered an individual or sole proprietor under the tax law.
Special Tax Treatment for Qualified Traders
The key tax implication for achieving trader status is being able to use the Mark to Market (MTM) accounting election. Because gains and losses are regarded as ordinary income under MTM, all losses can be deducted in the year that they occur. Traders are also not bound by the $3,000 net capital loss limitation, which means they are receiving the maximum tax relief in the current year. Qualified traders can also write up to $19,000 a year for services and equipment related to trading. Another tax tip would be to use MTM to avoid the 30-day wash sale rule, which disqualifies loss deductions on "substantially identical" securities bought within 30 days before or after a sale.
Since it is almost impossible for even day traders to qualify as "traders" under the IRS guidelines, the only way to ensure receiving an equivalent tax treatment is to create a separate corporate entity to trade through. By incorporating one's trading business, all expenditures become tax deductible. All companies can elect to take the Mark to Market elections and can avoid the wash sale provisions. Because the trading company is a legal entity, it usually receives less IRS scrutiny under the assumption that no one would go the issue and expense of forming a company without being committed to trading as a business activity.
Other Business Structures
For most traders the creation of either a limited liability company (LLC) or a limited partnership is enough to provide the business with the best tax treatment. Very successful traders can shelter more income and achieve greater asset protection by creating more complex corporate structures. This business structure usually consists of a "C" corporation that acts as the managing partner of the LLC, or the General Partner of the limited partnership. This structure allows individuals to use the significant management fees paid to the corporation to set up a corporate pension fund or pay for medical or college tuition reimbursement accounts. Depending on the amount of income generated annually, the business structures and corporate activities can be adjusted to provide the optimum tax benefit and level of asset protection available.
by: Matt kaldor
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