One of the most common questions traders ask me is: should I incorporate? Then there are the follow up questions about which entity is the best one: LLC, Corporation, S-Corporation or perhaps a partnership. What state should it be in? Delaware or maybe Nevada? Should I include my spouse as an owner? Do I need to pay myself a salary? Here are some answers to these common questions.
Sole Proprietorship. Obviously, you can conduct your trading business as a sole proprietorship. However, there are many disadvantages to this strategy. Your trader status could hinge upon your ability to prove to the IRS that your trading enterprise is a legitimate business. Failure to do so could cause your trader tax status to be denied, consequently leading to the disallowance of your mark-to-market accounting method and your ordinary losses denied and capped at only $3,000, thanks to the capital loss limitation rule.
Mainly, you will need to deal with the IRS’s vague definition of what constitutes a trader for tax purposes. A more cautious option is to conduct your trading through a more formal legal entity.
What makes a sole proprietorship so risky for traders is that neither Congress nor the IRS has clearly defined what constitutes a trader, and the guidelines continue to evolve through tax court case law. As a result, the trader status you enjoyed last year may not protect you and your business this year. The guidelines are largely based on cases involving individual taxpayers (sole proprietors), which the IRS typically views with far more suspicion than more formal business entities.
Sole proprietors are also more exposed to personal financial risk than legal entities. Because your personal and business assets are not separated, a business misstep could cost you your house, your vehicle and other personal assets.
Another disadvantage sole proprietors have is that trading income is not considered self-employment income, thus you are not allowed to make tax-advantaged retirement contributions. Tax deductions are extremely limited for sole proprietors as well. Sole proprietors who do not select mark-to-market accounting are put in an odd position of reporting income on Schedule D as capital gain, but expenses on Schedule C as ordinary income, a discrepancy that can draw unwanted attention from the IRS.
The schedule C will constantly show losses as no income is reported on it, only expenses. This will make the IRS think that you are conducting a losing business and after so many years, they will probably want to review your return more closely. It should be clear that you want to avoid an IRS audit, because it is time-consuming, stressful, and costly.
What about Entities? A good reason for forming a trader entity is that it allows you to establish a retirement plan or other tax deductible and tax-deferred employee benefit plans. Furthermore, an entity can deliver business tax breaks to your spouse or other family members.
If you missed the April 15 deadline to file for the mark-to-market accounting method, you can form an entity to elect mark-to-market for the rest of the tax year. This is a huge benefit, as I discussed in last week’s article devoted to mark-to-market accounting.
Entities are also useful for part time traders who just barely qualify for trader tax status and want to use an entity to reduce their chance of IRS questions. Keep in mind that you will still have to qualify as a trader and achieve certain levels of business activity.
The primary legal entity structures are: limited partnership, limited liability company (LLC), S-Corporation, and C-Corporation. Entities must be registered within the state where business is conducted. If you pay payroll to fund retirement accounts or medical insurance, your entity must be registered in your home state; in rare cases, however, some traders may wish to register their entity in a state that does not tax entity income.
When it comes to entities for traders, the correct and best way is also the simple and easy way. We actually advocate a pass-through entity in your home state. For the appropriate selection for you, we recommend you attend a personal consultation with one of our professional consultants as there is no one legal entity or structure that is right for everyone.
The main reason to form a legal entity is to stabilize your business activities and expense deductions. Without a business entity, your trader tax status could turn on the ruling of the next tax court judge. The tax status of legal entities, however, is well-defined by the IRS. No more worrying about whether you are suddenly going to face a different and unfavorable tax status.
By forming a legal entity and choosing the mark-to-market accounting method, your business deductions can range from $10,000-$20,000 annually and if you experience substantial losses, you’ll be able to fully deduct those as ordinary losses as well, thanks to the $3,000 capital gains waiver.
Final Thought. In conclusion, it seems that there are many rewards and reassurance of trading through a business entity. Entity benefits outweigh the risks and uncertainty of a sole proprietorship. So the question is not why should you form a legal entity, but why wouldn’t you?
Be sure to visit our OTA Tax Pros website to find out how you can attend a free tax planning webinar.
- Michael Atias