Contrary to popular belief, even among tax professionals, just setting up an entity in which to trade does NOT make that entity a “trading” entity and therefore bypass the trader in security requirements. Otherwise, why wouldn’t every investor do it?
This is a similar argument to having a vehicle painted with a logo, telephone number and other advertising and expect the vehicle to be completely deductible. Well, why wouldn’t it be? Because the vehicle owner still has to substantiate his business usage.
Thus, the trader in securities still has to meet the requirements of a trader and the entity’s investment activities must rise to that level.
We are now going to show you various reporting scenarios assuming you have an entity setup in which you are investing or trading.
Examples will be provided for an individual and two types of flow-through entities, a partnership (Form 1065) and an S-Corporation (Form 1120S) as active traders and as an investment entity. As suggested in the Entities discussion, stick with flow-through entities unless there is some major overriding consideration to setup a C-Corporation or trust, such as liability protection or family issues.
Mike made the following trades during 2008:
300 shares of AAPL
Nov 08 90 Short Call; STO $12.80 Expired
Dec 08 90 Short Call; STO $4.90 Expired
Jan 09 90 Short Call; STO $5.50 Expired
500 shares of WMT, 10/10/2008 at $48.75
Nov 08 55 Short Call; STO $2.24 Expired
Dec 08 55 Short Call; STO $1.96 Exercised
500 shares of RIMM
Nov 08 45 Short Call; STO $5.40 Expired
Dec 08 35 Short Call; STO $5.70 Expired
Dec 08 40 Short Put: BTO $3.75; STC $2.96
Jan 09 45 Short Call; STO $4.75 Expired
500 shares of MCD
Jan 09 90 Short Call; STO $2.20 Expired
Mike incurred the following expenses related to his securities transactions:
Investment advisory newsletter - $600
Computer - $1,500 (exclusive use); MACRS 5-year
Monitors - $900 (three); MACRS 5-year
Furniture - $750 desk, monitor stand; MACRS 7-year
Software - $250 Microsoft Office 2007; S-L 36 months
Fiber optic data line - $40/month
Travel - $1,500 to investment conferences
Airfare & Hotel - $1,300
Meals & Entertainment - $200
TOTAL EXPENSES - $5,980
Other information for Mike:
Mike’s spouse has W-2 wages of $60,000
Mike has two children that are his dependents
Mike has itemized deductions of:
Real estate tax - $5,000
Mortgage interest - $10,000
Charitable contributions - $2,500 (cash)
Scenario 1 - Mike reports as an Investor
All investment gains and losses are reported on Schedule D and investment-related expenses reported on Schedule A
Scenario 2 - Mike reports as a Trader without an entity
Mike’s expenses from his trading business are reported on Schedule C - note that he has obtained an EIN - and his trading gains and losses are reported, as before, on Schedule D
Scenario 3 - Mike reports as a MTM Trader without an entity
Mike made a valid and timely MTM election during 2008. As before, he reports his expenses on Schedule C but now uses Form 4797, Part II to report his trading gains and losses. Also, for 2008, the first year of his election, he will make a Sec 481(a) adjustment as well.
Scenario 4 - Partnership/LLC that does not qualify as a Trader in Securities
Mike now has setup an entity - either a partnership or LLC - that will file Form 1065 but his securities transactions DO NOT qualify for trader status. Mike then flows through the partnership/LLC items via his Form 1065 Schedule K-1 to his individual tax return on Schedule E and Schedule A.
Scenario 5 - Partnership/LLC that qualifies as a Trader in Securities
Mike’s entity now qualifies as a trader in securities and the appropriate gains/losses and expenses flow-through to his Form 1040 via Schedule K-1.
Scenario 6 - Partnership/LLC that qualifies as a Trader in Securities and has made a MTM election
Same facts as Scenario 5 but now the Partnership/LLC has made a mark-to-market election, similar to Scenario 3 but for the entity.
Scenario 7 - S-Corporation that does not qualify as a Trader in Securities
Same as Scenario 4 but this time Mike’s entity is a corporation that has filed Form 2553 to elect to be taxed as an S-Corporation. An S-Corp is a flow-through entity also and his investment activities will be reported to him on Schedule K-1.
Scenario 8 - S-Corporation that qualifies as a Trader in Securities
Mike’s S-Corp now qualifies as a trader in securities and the appropriate gains/losses and expenses flow-through to his Form 1040 via Schedule K-1.
Scenario 9 - S-Corporation that qualifies as a Trader in Securities and has made a MTM election
Same facts as Scenario 6 but now the entity is an S-Corporation and has made a mark-to-market election, similar to Scenario 3 but for the entity.
Skim down the following list of scenarios and find the one that most meets your situation. Click on the “Form 1040” icon to the left to see what the tax return(s) for that scenario would look like.
If you have any questions about these scenarios, please feel free to email me.
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