Trading Entities
Most people want to setup a distinct Trading Entity in order to take advantage of potential tax benefits and possible liability issues.
However, I have heard too many times, from those who are completely uninformed about such things:
"Just setup an entity and you can deduct everything."
That could not be further from the truth. However, there are advantages and you will discover most of them here.
Be sure to explore the following links as well:
An investor/trader may setup an entity under their respective state rules and trade in it. Here is the general process:
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Setup the new entity - online* - under your domicile state rules
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Obtain a taxpayer identification number from IRS, again, online
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Setup a new account at your broker titled exactly as the new entity is titled. For example, if your new entity is called “Make Big Money, LLC” with your state, the account name at your broker should be titled “Make Big Money, LLC”
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Consider setting up a bank account, if you can get one for little or no monthly fees, with the same title (recommended)
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Transfer your security holdings into the new entity at the broker
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File a tax return for the new entity, depending on the type of entity formed (see below)
Why should you do this?
This is a short question but there are a myriad of answers, some of which could be:
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You barely qualify or do not qualify for trader status, using conservative qualification criteria discussed in the Trader section
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You do qualify for MTM trader status but missed the election deadline
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You want to fund a retirement plan or obtain some other benefit plan such as health insurance
Keep in mind, this is a serious undertaking. Now you have another entity you must manage and report to various state and federal agencies. Failure to report can result in substantial penalties.
Also, just setting up an entity does NOT necessarily entitle you to deduct a number of “ordinary and necessary” business expenses. If you do 50 (or even 350) trades in your entity and then deduct your auto, home office “for the convenience of your employer,” employee benefits, etc., you may have some serious questions to answer from the IRS and/or your state revenue department. (See Court Cases)
So, you’ve decided you want/need an entity. What now?
Entity Selection
Sole Proprietorship
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Really not a separate entity but represents the default for a trader without a formal entity setup
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No liability protection, which can have implications for traders
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Subject to self-employment tax at 15.3% of Net Earnings from Self Employment (Note: Simply trading as a sole proprietor is NOT subject to self-employment tax since trading income is not “earned” income)
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A trader will show no gross receipts or sales which can be an IRS “red flag” unless properly disclosed
Corporation
Two types: C Corporation (default) & S Corporation (election required)
C Corporation:
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Provides potentially less cumbersome benefits for owners
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Corporations result in potential double taxation for employee/shareholder
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Pays its own tax
S Corporation:
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Status must be elected after forming corporation (filing Form 2553 - new form/old instructions)
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Flow-through entity taxed on shareholder’s individual income tax return
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Benefits similar to C Corporations but reporting complexity
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Proper planning can minimize FICA (Social security & medicare)
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If not a personal services corporation then no self-employment tax (Current IRS hot topic)
Partnership
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Little or no liability protection for general partners
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Limited partners do enjoy limited liability, up to their investment
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No income tax paid at entity level
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Net income flows through to partners
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Default entity for husband-wife trading operation
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Trading income not subject to self-employment tax, whereas flow-through from a partnership to general partners usually is subject to self-employment tax
Limited Liability Company
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Owners are “members”
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May have single or multiple members
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Under the “check-the-box” IRS regulations, may elect to be taxed as a sole proprietorship (default for single member LLC), partnership (default for multi-member LLC) or corporation
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If corporate status elected (file Form 8832), default is C Corporation but may also elect S Corporation status (file Form 2553 with Form 8823)
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Provides owners with limited liability
Which should you choose?
Each entity has its own advantages and disadvantages. However, here are some general principles to help you decide.
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Check with your state to determine if reporting requirements exist for a particular type of entity. If so, this could add to the cost of compliance.
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Does your state require a formal agreement? General partnerships may or may not, limited partnerships probably will and corporations and LLC’s definitely will.
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Keep it simple. Do not setup an entity you do not fully understand! It will cost you money to set it up and if you decide to change it will cost you more.
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Stick with flow-through entities such as partnerships, LLC’s and S Corporations. This way your new trading entity should not owe tax itself.
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Also, you may qualify for the Qualified Business Income deduction under the new tax law (TCJA enacted in December of 2017)
* Setup Your Entity Online
Here are two websites you can use to setup your trading entity:
Other non-entity services available and more expensive
Less expensive and more hands-on; More information and a guide here