DETAILS ON DIFFERENT TYPES OF ENTITIES:

Some benefits of using an entity - Some drawbacks of using an entity.  see Benefits & Drawbacks 

Securities Trading may be done within any number of legal entities.  see Which is "best"? 

The most common entity forms that can be used to operate your Trade or Business of Securities Trading include the:

Sole-Proprietorship    (Part-time traders)
article: Where do you go after you outgrow your sole-proprietorship

Corporation    
     Out-of-State Corporations     (Don't be mislead)
     Corporation taxed as a C-Corp
     Corporation taxed as an S-Corp
     B Corporation
     Benefits Corporation

General Partnership, Syndicate, Group, Pool or Joint Venture
Family General Partnership
Limited Partnership (LP)
Limited Liability Limited Partnership (LLLP)
Family Limited Partnership (FLP)
Charitable Family Limited Partnership (CFLP)
Limited Liability Partnership (LLP)
Family Limited Liability Partnership (FLLP)
Limited Liability Investment Company or Hedge Fund
Syndicated Investment Partnership
Limited Liability Company (LLC)
     LLC taxed as a Sole Proprietorship
     LLC taxed as an Entity's Disregarded Entity
     LLC taxed as a Partnership
     LLC taxed as a C-Corporation
     LLC taxed as an S-Corporation
     Series LLCs
Any Partnership (from above) electing out of subchapter K

International Business Company (IBC)
Controlled Foreign Corporation (CFC)
Passive Investment Holding Company (PIHC)
Passive Foreign Investment Company (PFIC)
Active Foreign Reinsurance Company
Passive Investment Company (PIC)
Qualified Electing Fund (QEF)
Personal Holding Company (PHC)
Foreign Personal Holding Company (FPHC)

Grantor Trust
     Living Trusts
Complex Trust
IRA, self-employed 401k or other Retirement Plans

IRA, self-employed 401k or other Retirement Plan deductions

Avoid California Double Taxation with an Out-of-State Entity
California law that traders ignore at their own peril


IRS' list of types of Organizations and Structures:
https://sa2.www4.irs.gov/modiein/individual/help/all_organizations_type.jsp

Do it yourself, using TraderStatus.com's assistance: Legal Entity Formation Services for all 50 States
 

SOME BENEFITS:

• Far less likely to be selected for an IRS audit (if properly prepared by a tax professional).
• If selected for an audit, the typical IRS arguments against a taxpayer for having other interests and other sources of income are moot (if a proper separation of personal and corporate operations is maintained).
• Taxpayer's who only have time to trade part-time use entities to get around this IRS bias.
• Retirement plans can sock away money now to grow without paying taxes each year on the income.
• The high-exposure Office in the Home deduction is replaced with a §119 rental allocation for renters or a §162 deduction for utilities, repairs and insurance expense allocations for homeowners.
• Meal expenses under §119 can be fully deductible.
• Child care or other employee perks are deductible under §125.
• Medical insurance can be partially deductible for some entities with employees or fully deductible for C-corps with employees.
• Medical expenses over and above what insurance pays for may be deductible for C-corp employees.
• Generally, expenses are "more justified" when deducted by an entity; in particular: automobile, travel  and entertainment expenses.
• Generally, equipment depreciation and the related §179 deduction are more likely to be accepted "as is" when taken by an entity.
• There's a limited amount of asset protection via "the corporate shield."
• More sophisticated structures using multiple entities can offer even stronger asset protection.
• If you can establish a presence of "nexus" in a low-tax or no-tax State, you can reduce your home State income taxes.
• As an employee of your own entity, you can skip paying quarterly estimated taxes, declare yourself a bonus in December and have the withhold taxes from that bonus retroactively apply to the three prior quarterly due dates.
• An entity may elect Mark-to-Market as soon as it is formed, whereas an individual must only elect in advance, between January 1st and April 15th.
• An entity may be terminated when it no longer serves it's original purpose.  Terminating an individual trader, on the other hand, is quite painful!

SOME DRAWBACKS:

• They cost money!  Often running several hundred to over a thousand dollars to establish and maintain annually.
• If tax returns are not professionally prepared the chances of audit are often actually increased, under the theory that an entity tax return is too complicated for an individual to accurately prepare himself.
• Office in the Home deduction is more complicated or prohibited outright, because the individual himself no longer runs the business, rather the entity does (but see the §119 deduction above).
• "Requires" maintaining a separate set of books and records.  Separate bank account and separate brokerage account are highly desirable.
• The paying of a salary is necessary for several of the employee related benefits, and therefore the amount of the salary is subjected to FICA tax, Medicare tax and Unemployment taxes.
• Care must be taken to comply with the employer tax laws for timely paying and filing quarterly payroll tax returns,

 
Which is "best"?
To decide which form of business organization is appropriate involves the consideration of such factors as the ease of creation, the liability of the owners, tax considerations, and the need for capital. Each form has  advantages and disadvantages that indicate when it is most useful.

The entities with highest likelihood of IRS audit are the sole proprietorship trader and the sole proprietorship trader that has elected mark-to-market.  The IRS and Tax Court challenges here are often based on the amount of other, extracurricular activities that the individual may have going on in addition to his trading activities such as: employment at a "day job," other investment portfolio activity, taking time off, other odd money making ventures, hobbies and social activities, etc.

By placing your trading activities in a separate entity, such as a C-Corp, an S-Corp, a  multi-member LLC or a Family Partnership that is dedicated solely to securities trading, you can effectively eliminate most of the extracurricular activity challenges the IRS might bring up.  The "odds" of being selected for IRS audit in the first place is lower for these other entities as well.

The "downside" is higher compliance costs (State fees, CPA fees, Legal fees, Bank fees, etc.) and the time and effort with the formalities to properly maintain the entity.  Due to inadvertent missteps, taxpayers can lose some of the tax benefits when these formalities are not handled timely, consistently and properly.  This can happen when the owners just don't have the TIME, or DESIRE to handle the paperwork because they are spending twelve hours a day following the markets and trading!

Potential solution for traders who what to trade and not get bogged down with the bookkeeping and corporate functions: There are financial affairs managers that high-wealth individuals such as actors, ball players and other entertainment people hire to keep their corporations in proper order while they tend to their chosen trade or profession.  And you can certainly hire such a management company.  This same concept is something TraderStatus.com is looking to provide if the demand is out there.  My current thinking is a Connecticut LLC formed with a TraderStatus.com designee and yourself as members, where all the day-to-day business (bill paying, payroll, pension compliance, government mailing, etc.) is taken care of right here, leaving you to trade without getting into the details of compliance yourself.  This seems to have the potential of a win-win situation for traders who want the benefits of a multi-member LLC but don't have the time, knowledge or desire to bother with all the proper paperwork and overhead.  Connecticut may also have preferential asset protection against charging orders under RULPA.   If this is of interest, let's talk.

Most full-time traders operate as sole proprietors:
The most common of these entities, and the easiest one to operate your Trade or Business of Securities Trading in is the Sole-Proprietorship.  The sole proprietor taxpayer likely already has several brokerage accounts, pays low non-professional real time quote fees, and files federal form 1040 for his taxes.  All brokerage firms understand how to open accounts for sole proprietors (a/k/a individuals).  These are generally the easiest accounts to open and to fund and the fees charged are generally not any higher than for the other available forms of legal entity.

With a sole-proprietorship your creditors (e.g. margin account loans) can make claims against both your trading business accounts and your personal assets.

A sole-proprietorship is the only form of securities trading entity strictly prohibited from establishing a retirement plan (IRA, Keogh, Profit Sharing Plan, Money Purchase Plan, Defined Benefit Plan, Defined Contribution Plan, and so on) for yourself, although you can establish one for your employees, which could include your siblings, spouse, children or other relatives.

A Securities Trader operating as a Sole Proprietor "merely" needs to add in a couple forms to his regular IRS form 1040: a schedule C and any number of these forms: Schedule D, form 4562, form 4797 and form 8829.

Due to the complexity of trader status tax work it is oftentimes advisable that a professional (such as us!) be retained to plan and prepare all your compliance tax work.  But many sole proprietors do their own taxes.

Part-time traders and other special situations:

IRS Publication 535 Business Expenses
Deducting Business Expenses
If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit.

The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether:

IRS Regulations - Activity not engaged in for profit defined
§1.183-2(b)(1)-(9)
In determining whether an activity is engaged in for profit, all facts and circumstances with respect to the activity are to be taken into account. No one factor is determinative in making this determination. In addition, it is not intended that only the factors described in this paragraph are to be taken into account in making the determination, or that a determination is to be made on the basis that the number of factors (whether or not listed in this paragraph) indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa. Among the factors which should normally be taken into account are the following:

Practical thoughts - additional things to do to support your position that you or your entity truly are in a for-profit trade or business:

• Open a checking account for the business, separate from a personal use account
• Obtain a credit card for the business, separate from a personal use card
• Take a training class, attend a seminar, buy books on how to make the business profitable
• Set up a budget for the business and/or a projection showing goals and profit ability in future years
• Document you plans, at least annually showing goals for the year to make the business profitable
  
  
   

The Internal Revenue Service Frequently Asked Questions about trader status includes the following statement:

"Basically, IF your day trading activity goal is to profit from short-term swings in the market rather than from long-term capital appreciation of investments, AND is expected to be your primary income for meeting your personal living expenses, i.e. you do not have another regular job, your trading activity might be a business."

Does this say you must be a "full-time" trader?   No, it does not.  It says that if you are a full-time trader that you might qualify to file under TraderStatus.  That's not to say that a part-time trader might not also qualify to file under TraderStatus.  But this begs the obvious question:  Do you want to be the lucky one arguing this fine point with an IRS auditor while she's shaking her head as she peers down looking at all your deductions?

Part-time traders or anyone seeking a more sophisticated approach to their trading, estate planning, asset protection and their taxes should seek to establish an insulating entity from which to operate their trading activity.  An LLC or S-Corp for example, properly established, can be set up to trade securities full-time as its one and only business even if the individual himself has other conflicting activities (such as a full-time day job).
 
A newly established legal entity may elect the Mark-to-Market method of accounting unencumbered by the restrictive "April 15^th deadline."  For individuals who have missed the April 15^th filing date, forming a legal entity is an alternative to waiting until the following year's April 15^th filing date.

Most common is the use of pass-thru entities which themselves pay little or no tax, but rather pass-thru the net business activity which is then taxed to the owners in proportion to their investment interest in the entity.  Note that while "investments" in stocks and securities is a "dirty word" when it comes to the business of Securities Trading, it is just fine for an individual to have a direct active investment in a trading entity.

More sophisticated tax planning may utilize entities that are taxed directly (the C-Corp, for example).  Several of the Trader Status business expenses are reserved for creative (but fully legal) use of the C-Corp.  The C-Corp may be your primary trading vehicle, or perhaps it might be a member/part-owner of your LLC or Family Limited Partnership which allows you to split some of your annual profits off to the C-Corp to be sheltered by those special deductions, while the remainder is taxed at personal tax rates of the trader and other family members (including the children, in the lower tax brackets).

A Securities Trader operating as an LLC and/or corporation needs to file a number of tax forms besides his regular IRS form 1040.  For example IRS forms 1065, 1120, 1120S etc. and any number of these forms: Schedule C, Schedule D, Schedule E, form 2106, form 4562, form 4797 and form 8829.

Due to the complexity of preparing and coordinating all of these tax forms, it is imperative that a professional (such as us!) be retained to plan and prepare all your compliance tax work.

IRS FAQ (circa 2005)

I buy and sell stocks as a day trader using an online brokerage firm. Can I treat this as a business and report my gains and losses on Schedule C?

A business is generally an activity carried on for a livelihood or in good faith to make a profit. Rather than being defined in the tax code, exactly what activities are considered business activities has long been the subject of court cases. The facts and circumstances of each case determine whether or not an activity is a trade or business. Basically, if your day trading activity goal is to profit from short-term swings in the market rather than from long-term capital appreciation of investments, and is expected to be your primary income for meeting your personal living expenses, i.e. you do not have another regular job, your trading activity might be a business.

If your trading activity is a business, your trading expenses would be reported on Form 1040, Schedule C, Profit or Loss from Business (Sole Proprietorship) instead of Form 1040, Schedule A, Itemized Deductions. Your gains or losses, however, would be reported on Form 1040, Schedule D, Capital Gains and Losses, unless you file an election to change your method of accounting.

If your trading activity is a business and you elect to change to the mark-to-market of accounting, you would report both your gains and losses on Part II of Form 4797, Sales of Business Property.

Corporation: (also see C-Corp and S-Corp below)
This is the most formal of all business organizations: a state-chartered legal entity. It is owned by shareholders, whose losses are limited to the amount of their investment. A corporation may own real property and can sue or be sued in the corporate name. Shareholders are not personally liable for the corporation's debts; the corporation's assets are protected from individual shareholders' debts. There are three types of corporations, "C", "S" and non-profit. The difference is in the way they are taxed: 

• A "C" corporation pays federal and state income taxes on earnings; when shareholders receive dividends, they are taxed again.
• An "S" corporation generally does not have to pay federal income tax; its shareholders pay taxes on their share of the income on their personal tax returns. The "S" corporation therefore escapes the double taxation of a "C" corporation.
• Tax filing status varies according to type of non-profit. There are many filing types and the type must be determined when filling out corporation papers.
• Note: Foreign corporations (including companies headquartered in another state or country and doing business in your home state) have a separate tax obligation.
• Under IRS Code §7701 there are several "levels" of formality that I have seen misused by well-meaning "tax advisors" in recent years:
  • the "statutory" corporation: where the State has recognized the entity as a corporation. Usually, corporations are created under corporate statutes of a particular State and this ends the matter for the Service. The Service will rarely interfere with the State's determination that an entity is a corporation and that the entity is taxable as a separate entity. For example, a parent corporation and its corporate subsidiary are recognized as separate taxable entities so long as the purposes for which the subsidiary is incorporated are the equivalent of business activities or the subsidiary subsequently carries on business activities. Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438 (1943); Britt v. United States, 431 F.2d 227, 234 (5th Cir. 1970). That is, where a corporation is organized with the bona fide intention that it will have some real and substantial business function, its existence may not generally be disregarded for tax purposes. Britt, supra. To disregard the corporate entity requires a finding that the corporation or transaction involved a sham or fraud without any valid business purpose, or a finding of a true agency or trust relationship between the entities. G.C.M. 39326 (January 17, 1985); G.C.M. 35719 (March 11, 1974).
  • the de jure corporation: A corporation may be found to exist, even though the State's Secretary of State has not recognized such corporation. One such non-statutory corporation is a de jure corporation that exists where there has been full compliance, by the incorporators, with the requirements of an existing law permitting the organization of such corporation, but the entity is not a "statutory" corporation because the state has failed to recognize the entity as a corporation. A de facto corporation is a corporation existing under color of law and in pursuance of an effort made in good faith to organize a corporation under the statute. For example if the incorporators "crossed all the T's and dotted all the I's," but the filing clerk lost the file, then that organization might qualify as a de jure corporation.
  • the de facto corporation:  A corporation may be found to exist, even though the state's secretary of state has not recognized such corporation. One other such non-statutory corporation is the de facto corporation. For example, if the incorporators failed to sign one of the filing documents, then that organization would probably not qualify as a de jure corporation, but it might qualify as a de facto corporation. Not all states recognize either de jure corporations or de facto corporations.
    • FYI: In law the term "de facto partnership" has been used to refer to arrangements that should be regulated as if they are partnerships, because their substance is similar to that of partnerships although their form is not.  The concept of "de facto partnership" is used in some theoretical writings, and is also found in Alabama State Bar Op. 89-15 (Mar. 2, 1989), which advises that certain space sharing circumstances may create de facto partnerships; the opinion is noted in Arthur Garwin, Suite Harmony: Protecting Client Confidentiality While You Share Space, 78 A.B.A.J. 88 (Mar. 1992). There is no judicial authority for enforcing the antipartnership rules against a de facto partnership.  Whereas, a de facto partnership has no real meaning as a separate entity in tax law other than referring to domestic partners or a common law marriage between two people.  expl: "They've invited Joyce and her de facto to the party."
  • a corporation by estoppel: In a case involving contract creditors contracting with a corporation that hadn’t gotten its certificate filed, if there’s no fraud by anybody, the contract is made in the corporate name, there was no individual guarantee from the shareholder then you have a corporation by estoppel, if not a de facto corporation. It takes a bit more to be a de facto corporation rather than by estoppel. If you’re de facto, it operates against tort and contract creditors, but if you’re by estoppel, it only applies to contract creditors who made a deal with you in the corporate name.
  • the "corporation sole:"  A type of unusual corporation that an Exempt Organizations specialist may encounter from time to time is the "corporation sole." A corporation sole is a type of corporation that is controlled by only one person in a designated position whose successor automatically takes over on that person's death or resignation. The purpose of the corporation sole is to give some legal capacities and advantages, particularly that of perpetuity, to people in certain positions which natural persons could not have. The corporation is limited in the main today to bishops and heads of dioceses.

• It's extremely important to keep the business and affairs of the corporation separate from the personal affairs of any stockholder, director or officer. This means setting up a separate bank account in the name of the company, maintaining separate records, and keeping separate books for accounting purposes.
• Directors need to hold periodic meetings, and shareholder must meet once per year to elect directors. Meetings can take place in person at your home, at a restaurant over a fancy dinner meal or by telephone. Be sure to make a written record of the items discussed and actions approved at the meetings in your corporate minute book (part of your "corporate kit" usually obtained when the corporation is formed).  Alternatively, you can sometimes get away with just having all the directors (or a majority of the stockholders) sign a statement approving corporate actions.
• A commonly cited ground for piercing corporate liability shields involves failure to respect corporate formalities.  Inadequate capitalization is frequently mentioned as a ground for piercing a corporate liability shield.
• Buy-Sell Agreements are needed to govern the assignment and transfer of ownership interests.  Generally, a stockholder is free to sell or transfer shares to anyone.  However, with small corporations where the stockholders act more like partners and each is integral to the success of the company, you may wish to consider placing restrictions on the transfer of shares.  Stockholders sometimes enter into such buy-sell agreements which give the terms for when and how shares can be transferred or sold.  A typical buy-sell agreement would state that if one stockholder seeks to sell shares to any third party, the other stockholders have a right of first refusal; that is, the other stockholders may purchase those shares at the same price. Only if the other stockholders do not purchase those shares can a stockholder sell to a third party.
• Each corporation must obtain a federal tax identification number using form SS-4, which use is similar to that of an individual's social security number.  In addition, state, county and city business licenses may also be required. Please check with your city and county to see which type of licenses are needed.

Out-of-State entities...
Summary:  Incorporating in Nevada or Delaware may not be the best for a small business. 1. You may ultimately pay more fees, since your home state wants their share and you'll have to pay a Registered Agent. 2. It's not that much quicker to form than in most other states. 3. Yes, their courts are pro-business, but that doesn't mean that they are anti-consumer. 4. Yes, you can be anonymous, but how important is that for a trader?  5. True, there are no DE or NV state taxes, but there will be in your home state.

Forming your C-Corporation outside of your regular state of residence is a sophisticated method of reducing or eliminating State income taxes.  Unfortunately there are far too many "bucket-shops" out there touting this as legitimate tax planning to individuals who pay anywhere from $2,500 to $9,000 for a "personalized analysis" that always ends up with them owning a one-shareholder Nevada C-Corporation (These type of bucket shops also work out of Delaware)

There are good reasons to incorporate in Delaware or Nevada, but it shouldn't cost any more than $1,000 to incorporate anywhere plus maybe a "registered agent fee" which here at TraderStatus.com we try to avoid, rather than push on you as an additional revenue generator.  Form your corporation with our assistance.

But do out-of-State corporations make sense for the one entity C-Corporation used for trading securities?  The answer for most traders is a resounding "NO."  The big reason is that you will have to qualify to do business in your home office and that process takes as much time and money as your out-of-State filing, thereby doubling your costs right off the bat!  Then you probably need to pay $200 to $500 a year for the out-of-State resident corporate agent, file papers and fees annually in two States, and all for what?

If your trading business operation takes place in your home office, for example, you still must pay home-state income taxes on this income.  Unless you are large enough to actually open an office in Nevada or Delaware and perform substantial operations there rather than performing those activities in your home-state then Nevada and Delaware tax havens are a waste of your time and money.

Once you are making good money on a consistent basis, then it is possible that an out-of-State entity will be legally beneficial to you.  Typically this is done in conjunction with one or more additional entities formed in your home-state.  Also see:  Avoid California Double Taxation with an Out-of-State Entity 

There can be some limited level of asset protection against charging orders under RULPA based on which state you form the entity in.  Use of a statutory close corporation may offer similar benefits.  You are well advised to see a local attorney if asset protection is what you are seeking.

Don't be mislead...
Sure, most anyone can form a corporation in a tax-haven State such as Nevada.  And if you leave all the money there while severing all connections with your own State of residence; it won't necessarily be taxed by your home-state (though it would then have the potential of being assessed punitive federal tax rates).  But if you want to USE the money yourself, you need to take it out of the corporation!  A salary, consulting fee, management fee, or administration fee paid to yourself would be taxed by your residence State.  A loan from the corporation to yourself can be attacked as a sham transaction.  A loan in excess of $10,000 must carry a fair market interest rate and that interest expense might not be deductible to you, while it is taxable to the corporation!  A loan with the full rate of interest generally cannot exceed much more than $250,000 because of the punitive "accumulated earning tax" which in effect forces the corporation to pay taxable dividends to the shareholders, making it taxable by the resident State, and double taxed by the IRS

There are several common punitive tax implications that owners of trader status C-corps need to be wary of:

• double taxation on gains (first on the corporate side and again when paid out as dividends to the shareholders).
• the accumulated earnings (AET) tax of 39.1% on top of the regular corporate tax rates that range from 15% to 39%.
• the personal holding company (PHC) tax of 39.1% on the corporation's "undistributed personal holding company income."
• the personal service corporation (PSC) tax of 35%.
• disallowance of losses under the "closely held C corporation at-risk rules."
• disallowance of losses under the "closely held C corporation and personal service corporation passive activity loss rules."
• the IRS can reallocate the income and deductions of a personal service corporation (with disastrous effects) back to it's shareholders if it was formed or availed of for the principal purpose of tax avoidance.  Defined as - if any one shareholder saved more than $2,500 in taxes as a result of forming the corporation rather than operate as a sole proprietorship.
• the IRS may disregard the corporate entity and allocate the income to the shareholders under the "assignment of income doctrine" by showing that the incorporation amounts to an anticipatory assignment of all of the controlling shareholder-employee's income to the corporation - if the service-performer employee is controlling the income received by the corporation.
• the IRS may reallocate income from a corporation to its shareholder-employees by completely disregard the corporate entity as a sham if the corporation does not have enough trading activity and the proper documentation, books and records to show that it carries on a legitimate trading business as a corporation.
• the IRS specifically reserves the right to reallocate income under provisions in effect before the reallocation rules were enacted.  In fact, the proposed regulations provide that these other rules can apply even to corporations that pass the $2,500 safe harbor test described above.
• for more on this, see this web site link.

"Creative" ideas such as having the corporation buy you a luxury automobile to cruse in, or a house to live in while you "safeguard" the corporate computers and software are faulty too due to the concept of "nexus."  What this means is the corporation holds assets that are located in a State other than Nevada, and as a result "nexus" (see the national nexus web site) is formed giving your residence State taxable income and the ability to find you, audit you and blow apart the little out-of-state tax-haven scheme.  Also see this 110 page PDF file by Ernst & Young about State Income Tax developments.

Another ploy being touted is to have two different/separate securities trader businesses (not a bad idea in itself).  One business operation is your own personal Schedule C sole proprietorship or an LLC and the other business operation is run out of a C-Corp.  After paying a small fortune for consulting advice you are then told to simply make all your gains within the corporation and taxed there -- and have all your losses reported on your Schedule C where they can shelter other income, such as your spouse's W-2 wages.   Another similar strategy is to convert the C-Corp into an S-Corp and to have all the losses in this M2M S-Corp while you have the gains in your non-M2M Schedule C, so that you can tax-shelter those gains by using up prior year capital loss carryforwards.   I can't help but to  wonder who is smart enough, ahead of time, to be able to make all the winning trades in one brokerage account and to have all the tax-benefit loss trades in the other brokerage account?!!    If there's any genius' out there who can accomplish that feat, why not just open the account to use for the winners to begin with and then not open any account for the losers?  Why buy losers to begin with, if you know about it before hand?  Why not just save all the trading money you'd have lost with this crazed scheme being promoted at the high-priced expert tax trader seminars?

While Out-of-State entities are not necessarily all they're cracked up to be, there are situations (such as in California) where the State has the gall to impose double taxation on their residents.  For example, in CA an LLC is subject to a "fee" of approximately 0.1% on gains, with an $800 annual minimum.  CA S-Corps pay 1.5% on gains, with an $800 annual minimum.  For these instances an Out-of-State entity can make sense.  See the link  Avoid California Double Taxation with an Out-of-State Entity below, for what we can offer you to completely eliminate these CA fees and taxes.

     Corporation taxed as a C-Corp:
Additional Benefits:
A limited amount of Federal income tax savings by shifting up to a maximum of approximately $250,000 of taxable income to the lower corporate tax rates.

A limited amount of State income tax savings by shifting up to a maximum of approximately $250,000 of taxable income to a State that does not tax corporate profits.

A fiscal year-end other than December 31, 200X may be chosen.  This can allow maximum year-to-year flexibility in deferring recognition of income.


Additional Detriments:
Because the tax attributes are not passed through, it is imperative that each year an accounting be taken before fiscal year-end to make sure the taxable income remaining within the corporation is the desired amount.  Fiscal year-end bonuses need to be paid out prior to ending your taxable year.

Caution: When considering year-end bonuses, the old "bonus out all the cash at year-end" trick can sometimes backfire due to any number of reasons including: a failed Sec 179 election, personal withdrawals or switches of operating funds, the purchase of a deductible automobile for the trading business and so on.


     Corporation taxed as an S-Corp:
Additional Benefits:
By availing yourself to the little know rule known as IRS Regulation 1.1366-1(b) you might be able to convert capital losses in old long-term dog stocks you've been holding into usable fully-deductible ordinary losses.

Additional Detriments:
The corporation must file a timely Federal election on form 2553 generally by the 15^th day of the 3^rd month of the year of the election.  If this is not the 1^st year of the corporation, there are additional C-corp/S-corp complications that need to be addressed.  Rev. Proc 98-55 offers some relief against the stringent time frame of this election period.  Most State recognize the Federal S-corp election, but other States require that their own additional election to be filed.

There are many other tricks and traps with the complicated structure of the S-Corp.  Some States do not treat a federally recognized S-Corp in the same fashion as does the IRS.  An ongoing relationship with a  CPA is really required to keep things on track, more so that with many of the other entities discussed on this web page.




     B Corporation:
Additional Benefits:
A "certification" given by B Lab to businesses that pass a socially responsible certification process. B Corporation is not a legal form and has no legal on income tax significance.

A B Corp can be structured legally as a C corporation, an LLC, or a sole proprietorship. A company can be certified as a B Corporation without ever incorporating as a benefit corporation.


     Benefits Corporation:
Additional Benefits:
A benefit corporation is a legal form that became law in Maryland on October 10, 2010. Legislation similar to that in Maryland will become law in Vermont in July 2011 and was recently passed by the New Jersey legislature.

An entity may be a benefit corporation under Maryland law without being a B Corporation. The Maryland law does not require that benefit corporations be certified as a B Corporation. Rather, it requires that benefit corporation's social and environmental performance be assessed by an independent third party that makes publicly available or accessible the following information:

• The factors considered when measuring the performance of a business.
• The relative weightings of those factors.
• The identity of the persons who developed and control changes to the standard and the process by which those changes were made.

The key difference is that the law requires a third party assessment, whereas a B Corporation is a certification.

General Partnership:
Two or more parties share business profits and assets by mutual agreement.  Each partner's actions are legally binding.  For federal income tax purposes, a partnership includes a syndicate, group, pool, joint venture or other unincorporated organization by means of which any business, financial operation, or venture is carried on and which is not a corporation, trust, or estate.

Tax Court has determined that a partnership exists when the economic benefits enjoyed by the co-owners results not from mere co-ownership of the assets, but from the pursuit together of a common goal. (Bergford 1993, Bussing 1988, Alhouse 1991)

Unfortunately some other web sites purporting a specialization in taxes for daytraders suggest that traders form so-called friends and family partnerships or hedge funds without first having a thorough understanding of all the appropriate tax rules.
A further discussion regarding the legitimacy (for income tax purposes) of a partnership where each partner's share of gains and losses is based on his own individual performance, rather than the group's aggregate performance is found here.  Here at TraderStatus.com we advise traders on how maximize their tax savings while complying with the law the way it is written and applied, but not based on "making up our own law" because it helps sell you more services.

Benefits:
Can be easy to form.  In some locations a simple hand-shake creates the partnership.

Partners may not get paid a "salary" or "wages."  In lieu of salary, earned income may be paid as "consulting fees" or "guaranteed payments to partners."   These are taxed to the partner (not to the partnership) for SECA purposes (similar to FICA and Medicare).

Once "earned income" is generated as per the above, you may receive (if desired and if structured properly) a tax deduction for payments made for health insurance and retirement plan contributions for yourself and family members.


Detriments:
Can be difficult to form properly.  A partnership is like a marriage, and therefore a "prenuptial agreement" generally known as a "buy-sell agreement" should be drafted by your own local attorney if there is any chance the partners may disagree, become disabled or die, leaving the survivor to contend with named or unnamed beneficiaries.

Every partner is jointly and severally liable for the acts of the other partners.  For example: if one partner provides capital only (as a silent partner) and the other partner does the actual trading and due to a bad turn in the market a margin call results in a complete wipe out of the account -  the brokerage could go after the silent partner account to restore the deficiency.

The ease of formation of a general partnership is actually a disadvantage, because co-participants may find themselves with joint and several liability and mutual agency powers even though their arrangement with respect to the business has not been clearly documented.




Family General Partnership:
A General Partnership who's partners are comprised of family members.  The purpose of which is usually to attempt to legally shift taxable income away from higher tax brackets, into lower brackets.  This is much less expensive to form and to operate than a Family Limited Partnership.

Other benefits and detriments are basically the same as for the General Partnership.

Limited Partnership (LP):
Originally designed to attract INVESTORS who invest capital but, by definition, do not take part in day-to-day operations.  As a result the Limited Partners' liability is limited to their investment in the partnership.  There must be at least one General Partner (often holding at least 1% equity interest in the partnership.  The General Partner manages the business (does the trading) and has unlimited personal liability.

This is much more expensive to form and to operate than would be for a General Partnership.  State "blue sky" laws may cause additional complexity.

Losses allocated to a Limited Partners may need to be recharacterized from fully deductible "ordinary losses" to deferred "passive losses"  under treasury Regulation § 1.469-5T which states that he will be denied ordinary loss treatment unless he meets at least one of the following three tests:

1. The individual participates in the activity for more than 500 hours during such year (700 hours per year in certain cases);
2. The individual materially participated in the activity (determined without regard to this paragraph (5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
3. The activity is a personal service activity and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

Limited Liability Limited Partnership (LLLP):
Similar to a Limited Partnership, except that the liability of all partners in a limited liability limited partnership  is limited to the amount of their investment in the firm.

An LLLP is a limited partnership that registers in the LLLP form.
The LLLP form primarily is used to convert an existing limited partnership previously created under state law. It also is used as an alternative to forming an LLC in those states that allow foreclosure of an owner's business interest, and forced liquidation of the business, by the owner's personal creditors.

Colorado, Delaware, Florida, Georgia, Maryland Nevada and Texas (and possibly others) recognize the LLLP.


Family Limited Partnership (FLP):
A Limited Partnership who's partners are comprised of family members.  The purpose of which is usually to attempt to legally shift taxable income away from higher tax brackets, into lower brackets and to offer some level of legal asset protection.  This entity is also used in more aggressive estate planning by transferring equity ownership from a parent (the General Partner) to children or grandchildren at rates that are discounted 10% to 20% due to the limited rights conveyed to Limited Partners .   More aggressive discounting that is usually audited by the IRS has gone as high as 40% to 50% or so.

Other benefits and detriments are basically the same as for the Limited Partnership.

The basics principals of a FLP may also be had by forming a Family Limited Liability Company.

This is much more expensive to form and to operate than would be for a Family General Partnership.

Pursuant to the recent 2003 Tax Court case, Estate of Albert Strangi v. Comm our Attorneys have provided this list of steps to take to secure that FLP assets stay out of your estate:

• Personal use assets, such as a personal residence, should not be held by the FLP.
• Assets to support your lifestyle should be retained outside of the FLP
• Multiple family members should contribute assets to FLP.
• FLP assets should be recorded in the name of the FLP, not held as nominee.
• More than one person should hold voting interest.
• A trust with an independent trustee should be a partner.
• Annual financial statements should be given to partners.
• Capital accounts should be properly maintained.
• Ownership percentages should be adjusted for any capital moved in or out.
• Distributions should be made pro-rata.
• Do not pay personal expenses from the FLP.
• Do not commingle personal assets and FLP assets.
• Avoid partner loans.
• Make all federal and state filing in a timely manner.

Charitable Family Limited Partnership (CFLP):
A Family Limited Partnership that makes a deductible charitable contribution of a partnership interest to the charity of their choice.  Though not usually used for Securities Trading, the CFLP can be a good supplemental estate planning tool.  See http://www.leimberg.com/software/charflps.html for more detailed information.

Other benefits and detriments are basically the same as for the Family Limited Partnership.

This is much more expensive to form and to operate than would be for other forms of Partnership.

Limited Liability Partnership (LLP):
Similar to a Limited Partnership generally with the exception that the General Partner does not have unlimited personal liability.  A partner in a registered Limited Liability Partnership is not individually liable for debts and obligations of the partnership arising from errors, omissions, negligence, incompetence, or malfeasance committed in the course of the partnership business by another partner or a representative of the partnership not working under the supervision or direction of the first partner at the time the errors, omissions, negligence, incompetence or malfeasance occurred, unless the first partner:   1) Was directly involved in the specific activity in which the errors, omissions, negligence, incompetence, or malfeasance were committed by the other partner or representative; or  2) had notice or knowledge of the errors, omissions, negligence, incompetence or malfeasance by the other partner or representative at the time of occurrence.



Family Limited Liability Partnership (FLLP):
This is a limited liability partnership (LLP) in which most of the partners, are related. All partners must be natural persons or persons acting in a fiduciary capacity for natural persons. Family-owned firms may benefit from the use of the family limited liability partnership (FLLP) form.
 

Limited Liability Investment Company or Hedge Fund:
Generally, an "investment company" is a company (corporation, business trust, partnership, or limited liability company) that issues securities and is primarily engaged in the business of investing in securities.  For our purposes here this basically means a "hedge fund."

Investment companies are regulated primarily under the Investment Company Act of 1940 and the rules and registration forms adopted under that Act. Investment companies are also subject to the Securities Act of 1933 and the Securities Exchange Act of 1934. For the definition of "investment company," you should refer to Section 3 of the Investment Company Act of 1940 and the rules under that section.

An investment company invests the money it receives from investors on a collective basis, and each investor shares in the profits and losses in proportion to the investor’s interest in the investment company. The performance of the investment company will be based on (but it won’t be identical to) the performance of the securities and other assets that the investment company owns.

Some types of companies that might initially appear to be investment companies may actually excluded under the federal securities laws. For example, private investment funds with no more than 100 investors and private investment funds whose investors all have a substantial amount of other investment assets, "accredited investors," are not considered to be investment companies - even though they issue securities and are primarily engaged in the business of investing in securities. This may be because of the private nature of their offerings or the financial means and sophistication of their investors. For additional information on these types of private investment funds, please refer to this link on hedge funds.

Hedge funds generally rely on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 to avoid registration and regulation as investment companies. To avoid having to register with the SEC the securities they offer, hedge funds often rely on Section 4(2) and Rule 506 of Regulation D of the Securities Act of 1933.

In the past, to be exempt from U.S. taxes, the investment fund could be managed in the United States but had to conduct the 10 functions known as the "10 commandments" through its offshore office. These functions consisted of:

1. communicating with shareholders,
2. communicating with the general public,
3. soliciting sales of its own stock,
4. accepting new subscriptions,
5. maintaining principal corporate records,
6. auditing its books of account,
7. disbursing certain payments,
8. publishing or furnishing the offering and redemption price of shares,
9. conducting director and shareholder meetings, and
10. making redemptions of its own stock.

Under current law fund managers can decrease costs and shift jobs back to the United States. However, many predict U.S. fund managers with non-U.S. investors have moved slowly to remove all offshore administrative functions because non-U.S. investors still may fear that investment in a U.S. fund without an offshore office could potentially subject them to U.S. taxes.

Syndicated Investment Partnership
The IRS web site discusses audit techniques here:: http://www.irs.gov/businesses/partnerships/article/0,,id=134701,00.html
http://www.irs.gov/pub/irs-utl/exhibit_12ptratg.pdf
 

Limited Liability Company (LLC):
This is a form of business organization combining the features of a corporation and a partnership (or sole-proprietorship).  An LLC is similar to a Corporation but without finance restrictions that require capital and surplus accounts and the need for a board of directors to manage its operations.  Also, like the shareholders of a corporation and the limited partners in a limited partnership, the owners of an LLC (called "members") are not personally liable for the LLC's debts; the members' losses are limited to the amount of their investment. Unlike limited partners, members of an LLC can take part in day-to-day operations. Like an "S" corporation and a limited partnership, an LLC does not have to pay federal income tax; its members pay taxes on their share of the income on their personal tax returns.

Two basic versions of the LLC exist: the one member LLC and the multi-member LLC.  Be aware that a one member LLC (unless a proper election to be taxed as a corporation is made) is disregarded or ignored for IRS tax purposes.  It is generally a wise move to form a multi-member LLC, rather than a one member LLC.

Most LLC statutes provide that members may appoint managers and officers to run the day-to-day affairs of the business, or that the members may reserve management to themselves.  To assure that the members are actively involved, the use of managers or officers is not desirable.

The securities trader must be alert to the passive loss rules which under treasury Regulation § 1.469-5T states that he will be denied ordinary loss treatment unless he meets at least one of the following seven tests:

1. The individual participates in the activity for more than 500 hours during such year (700 hours per year in certain cases);
2. The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
3. The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
4. The activity is a significant participation activity for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours (700 hours per year in certain cases);
5. The individual materially participated in the activity (determined without regard to this paragraph (5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
6. The activity is a personal service activity and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.
   

A web site devoted to provided everything you can imagine about LLC formations: http://www.llcformations.com/


     LLC taxed as a Sole Proprietorship:
All States except Massachusetts allow LLCs to be formed having only one member.  Per IRS guidelines these are "disregarded entities" for most tax related purposes.

Benefits:
Nothing really over an individual's sole proprietorship.  Perhaps some level of legal protection is available by having the assets held in the name of the LLC.  The tax forms used are form 1040, Schedule C, and Schedule D or form 4797.  Arguably, a somewhat lesser standard of material participation could be required for a member of disregard LLC than would be for a sole proprietorship, (Gregg v. U.S. 11/29/00).


Detriments:
Extra paperwork and confusion, basically for nothing.


     LLC taxed as an Entity's Disregarded Entity:
All States except Massachusetts allow LLCs to be formed having only one member.  Per IRS guidelines these are "disregarded entities" for most tax related purposes.

Benefits:



Detriments:




     LLC taxed as a Partnership:
Most States allow LLCs to be formed with two or more members.  The IRS has "check the box" regulations that default to taxation as a partnership.  The tax form used is form 1065.

Tax Court has determined that a partnership exists when the economic benefits enjoyed by the co-owners results not from mere co-ownership of the assets, but from the pursuit together of a common goal. (Bergford 1993, Bussing 1988, Alhouse 1991)

Benefits:
Members may not get paid a "salary" or "wages."  In lieu of salary, earned income may be paid as "consulting fees" or "guaranteed payments to members/partners."   These are taxed to the member (not to the LLC) for SECA purposes (similar to FICA and Medicare).

Once "earned income" is generated as per the above, you may receive (if desired and if structured properly) a tax deduction for payments made for health insurance and retirement plan contributions for yourself and family members.


Detriments:



     LLC taxed as a C-Corporation:
Most States allow LLCs to be formed with one, two or more members.  The IRS has "check the box" regulations that allow the LLC to elect to be taxed as a corporation.  The tax form used is form 1120.

Benefits:
A limited amount of Federal income tax savings by shifting up to a maximum of approximately $250,000 of taxable income to the lower corporate tax rates.

A limited amount of State income tax savings by shifting up to a maximum of approximately $250,000 of taxable income to a State that does not tax corporate profits.

Ability to pay yourself or family members, as employees, earned income in the form of a salary from the corporation.  This salary is subject to FICA (6.2% plus a matching 6.2%) and Medicare tax (1.45% plus a matching 1.45%) for a total tax of 15.3% of approximately $100,000 of your annual earned income (2.9% thereafter) which is credited to your ability to collect Retirement Social Security, Spouse's Retirement Benefits, Disability, Family Benefits, Survivors Benefits, Medicare, Medicaid, & Supplemental Security Income.  These extra taxes may run up to approximately $15,000 per employee earning greater than $100,000.

The salaries are tax deductible from corporate income in the year paid by the corporation (which generally must be the same year it is picked up as income by the family employee).

One half of the above tax (6.2% plus 1.45%) is tax deductible from corporate income when paid by the corporation.

In lieu of salary, earned income may be paid as "consulting fees."  These are taxed to the consultant (not to the corporation) for SECA purposes (similar to FICA and Medicare).

Once "earned income" is generated as per the above, you may receive (if desired and if structured properly) a tax deduction for payments made for health insurance and medical expenses, children's day care, "cafeteria plans" and retirement plan contributions for yourself and family members.


Detriments:



     LLC taxed as an S-Corporation:
Most States allow LLCs to be formed with one, two or more members.  The IRS has "check the box" regulations that allow the LLC to elect to be taxed as a corporation.  Taking that a step further, the corporation may then elect to be taxed under Subchapter S, thereby allowing most items to be passed through the corporation and taxed much the same as would be done with a partnership.  The tax form used is form 1120S.

Benefits:
A Sole proprietor or a single member LLC generally files on Schedule C, which because it always shows losses, can be subject to audit under the "hobby loss" rule as well as other audit programs that are run from time-to-time.  A single member LLC that elects to be taxed as a corporation does not file Schedule C, but rather files form 1120.  Such a corporation that elects to be taxed under Subchapter S would file an 1120S and then pass most items through the corporation to the sole-owner who in turn would report the numbers on his own form 1040, Schedule E.

A limited amount of State income tax savings by shifting up to a maximum of approximately $250,000 of taxable income to a State that does not tax corporate profits.

Ability to pay yourself or family members, as employees, earned income in the form of a salary from the corporation.  This salary is subject to FICA (6.2% plus a matching 6.2%) and Medicare tax (1.45% plus a matching 1.45%) for a total tax of 15.3% of approximately $100,000 of your annual earned income (2.9% thereafter) which is credited to your ability to collect Retirement Social Security, Spouse's Retirement Benefits, Disability, Family Benefits, Survivors Benefits, Medicare, Medicaid, & Supplemental Security Income.  These extra taxes may run up to approximately $15,000 per employee earning greater than $100,000.

The salaries are tax deductible from corporate income in the year paid by the corporation (which generally must be the same year it is picked up as income by the family employee).

One half of the above tax (6.2% plus 1.45%) is tax deductible from corporate income when paid by the corporation.

In lieu of salary, earned income may be paid as "consulting fees."  These are taxed to the consultant (not to the corporation) for SECA purposes (similar to FICA and Medicare).

Once "earned income" is generated as per the above, you may receive (if desired and if structured properly) a tax deduction for payments made for health insurance and retirement plan contributions for yourself and family members.


Detriments:
None except that this is a convoluted setup up and S-Corps in general have many traps for the unwary.  The IRS might someday challenge this whole set-up as a step-transaction having no valid business purpose if they thought they'd be getting more taxes by doing so. UPDATE: in October 2001 the IRS has given its blessing to our "LLC taxed as a C-corp taxed as an S-corp" proposal.  Proper, formal books and records are a "must" as this must show every sign of being a bona-fide business set-up.  This is a very sophisticated tax planning technique, best not attempted without careful consideration given to it.




     Series LLCs:
Delaware and several other State have started to allow these specialized LLCs to be formed.  It is said that they offer better asset protection than regular LLCs.

Benefits:

http://www.btshow.org/show/07/Debra-Tucker-PM.pdf


 

Any Partnership (from above) electing out of subchapter K:
Benefits:
Allows two or more parties to formally and legally pool their resources in the joint venture style of partnership entity to trade securities as investors (but not as traders), yet remain independent with respect to their tax filings.  Regs. §1.761-2(a)(2).


Detriments:
Requires extra paperwork and bookkeeping (mostly at the partner level, requiring the filing of form 1040, and a detailed Schedule D) as compared to a Partnership not electing out of subchapter K and just sending a Sch K-1 to each partner to include on their own Sch E as part of their form 1040 tax filing.

If the Partnership return gets audited, you can bet that each partner will get looked at too.

This is, in effect, a partnership tax return and two or more sole proprietorship tax returns. Therefore the tax compliance costs are higher than would be for just having a regular partnership or just having individual sole proprietorships.

International Business Company (IBC)
This is a corporation formed in a non U.S. country that is usually exempt from tax in the country where it is formed -- but it may not conduct any business in that country. For U.S. tax purposes, an IBC is generally treated the same as foreign corporation. U.S. persons who form and own a foreign corporation or an IBC may elect to be treated as a partnership or as a corporation by filing Form 8832 within the prescribed period of time. A single owner IBC may elect to be taxed as a corporation or as a disregarded entity.

Benefits:
Allows .

http://www.offshorEpress.com/cfc-ibc-tax.htm
 

Controlled Foreign Corporation (CFC)
This is a foreign corporation owned by United States persons that own directly, indirectly or constructively 10% or more of the voting power and more than 50% of the equity. The so-called "10% United States shareholders"

Benefits:
Allows .
 

Passive Investment Holding Company (PIHC)
Passive investments include, but are not limited to, certificates of deposit, commercial paper, accounts receivables, notes, stocks, bonds, and other business investments. Such investments produce income that is generally subject to state income tax. A Passive Investment Holding Company (PIHC) is an effective tool to centralize passive investments in a separate entity where they can be more effectively managed. It can also serve as a state tax shelter for the income produced by these assets.

Under the typical scenario, a corporation forms a subsidiary in a tax friendly state. The passive investments are transferred tax-free to the newly formed subsidiary. The operating company does not report, except in states that require unitary or combined reporting, the income produced by the passive investments because they are owned, managed and controlled by the subsidiary.

As for the PIHC, it escapes state taxation in its state of operation because it is set up in a low or no tax state or a state that does not tax income from passive investments. Suggested states where to locate the PIHC include Nevada, which has no income tax; Delaware, which exempts holding company income from corporate tax when the company's sole activity in the state is the maintenance and management of passive investments; or Michigan, where a deduction is allowed from the Single Business Tax base for dividends and interest.

The result of this strategy is that the operating company will significantly reduce their state taxable income through the exclusion of the passive investment income. The PIHC, in addition to avoiding tax in its home state, is not subject to tax in the operating company's state because it has no physical presence there. The net effect of this corporate structure has been the production of "nowhere" income that escapes income taxation in most states.

The PIHC strategy is complicated and difficult to implement. Therefore, the assistance of a competent tax advisors and competent outside legal counsel should be sought, to assist in the development and implementation of this strategy


Benefits:
Allows .

Detriments:
Requires .

Passive Foreign Investment Company (PFIC)
If a foreign corporation is a passive foreign investment company or mutual fund, special rules apply. The U.S. shareholders are required to report their share of the income of the foreign investment company on their tax return each year, or to pay a penalty on any deferred income from the foreign investment company. Any shareholder of a passive foreign investment company are required to file Form 8621 for each such fund. (In a few cases, a foreign company might be a foreign personal holding company without also being a passive foreign investment company, but that's an unlikely circumstance.)

If more than 50% of the foreign corporation stock is owned (directly or indirectly) by 5 or fewer U.S. persons, then the corporation will be a controlled foreign corporation. Those shareholders who own 10% or more of the stock are required to file Form 5471 each year with their tax return. If the foreign corporation has any "sub-part F income", the U.S. shareholders who own 10% or more of the stock will be required to include that income in their personal tax return even though it is not distributed by the corporation. The simplest explanation of "sub-part F income" is that it includes passive investment income and certain types of income derived from buying or selling goods or services to or from a related person or entity.

Those promoters who advocate the creation of a foreign corporation as way to avoid taxes on investment income are either ignorant of the U.S. tax rules relating to controlled foreign corporations or they are scoundrels who are not concerned about the problems they may be creating for U.S. persons.

If a foreign grantor trust or partnership is a 10% or greater shareholder of a controlled foreign corporation, then the grantor of the trust or the partners will be treated as shareholders of the foreign corporation. If such a trust or partnership owns any stock of a passive foreign investment company, it will need to file Form 8621.
http://www.rpifs.com/offshoretax/otcorp.htm


Benefits:
Allows .

Detriments:
Requires filing a QEF election to avoid punitive tax rates.


F.A.Q.
Definition of a PFIC

IRS releases final Mark-to-Market regulations for PFIC on April 29, 2004  T.D. 9123
 

Active Foreign Reinsurance Company (as popularized beginning in 1999 by Moore Capital Management)
If a foreign corporation is an active business then the passive foreign investment company or mutual fund, special rules do not necessarily apply. Ordinarily, hedge fund investors pay either the 39.6 percent rate for ordinary income on their profits or the lower long-term capital gains rate (if a QEF election is made), depending on how frequently securities are traded, plus an extra 3.8 percent surcharge stemming from the Affordable Care Act. But if they put money into a Bermuda-based reinsurer and have it invested in the hedge funds, any profits go to the reinsurer, which doesn’t owe tax on them. That allows the investors to defer taxes until they sell their stake in the reinsurer. Meanwhile, the money grows tax-free and the savings add up.

Example: Investing $100 million in a hedge fund that returns 10 percent annually for five years and paying the top marginal ordinary income rate on profits results in an after-tax gain of $50 million. If a Bermuda reinsurer holds the same investment, the gain is $77 million.