Types of Trader Entities

If you are ready to form your trader entity, you can sign up for ENTITY FORMATION TAX CONSULTING here.

Some types of entities that are most popular with traders:

  • Domestic Multi-Member Limited Liability Company (LLC), taxed as a partnership
    • ○ This entity structure offers great flexibility and versatility in allocating the taxable gains and losses and operating expenses to the LLC members, to be taxed on the members’ own individual income tax returns. The LLC itself pays little or no federal or State income tax. Special care must be taken so not to inadvertently get trapped by Prop. Regs. §1.1402(a)-2(d) when aggregating earned income for the year. LLCs may also offer some limited asset protection against “charging orders.” (Rev Ruling 77-137 says the plaintiff pays the taxes on the income, even if you, as the defendant keep full control the money and other assets)
      • ◙ Caution must be used with LLC’s that trade commodities (futures) when more than 35% of the member interest is held passively. This could cause the LLC to be considered a syndicate

    • ○ Owners (members) must number two or more and may include, for example: husband, wife, child (caution if less than two members are of legal age), other friend or relative, a corporation, a LLC, an estate or a trust.
      • ◙ we strongly prefer that all members hold more than a mere token percentage of ownership in the multi-member LLC. Owning relatively too small of a percentage interest in the LLC could be looked upon as peppercorn co-memberships which is possibly only one step away from sham co-members in certain circumstances. Especially if the co-members have not paid for their membership interest (they received a gift of the membership, for example).

    • ○ You must maintain an Operating Agreement, which at times can be cumbersome.

    • ○ The entity may elect to be taxed as an S-Corporation, if desired.
      • ◙ If an EIN has been issued to the LLC it may be retained pursuant to Regs. 301.7701-3 and 301.6109-1(h)(1) and the instructions to Form 8832.
      • ◙ Be sure to amend the LLC operating agreement to meet all S corporation requirements.
      • ◙ Then, if important, later convert to a state law corporation. This conversion ought to be an F reorg with retention of the EIN. See PLR 200528021 where a state law corporation with an S election converted to a state law LLC/S corporation and was allowed to retain its EIN

    • ○ Some statistics: This entity type surpasses in number all other entity types since 2002. In 2003 LLC’s filed 46.0% of all partnership tax returns, which is more than any other type. For partnership tax returns taken as a whole the IRS says that more than 50% of newly formed entities are in the category “finance and insurance,” which is the category traders file under. The LLC is becoming the defacto standard form of doing business for trader status taxpayers, soon to be surpassing even sole proprietorships.

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

    • ○ A web site that tries to answer Is LLC the best entity for your business? (note that this site is written from a regular non-trader perspective)

    • ○ Three Three Dumbest LLC Formation Mistakes

    • ○ Advantages of an LLC (web site) http://www.limitedliabilitycompanycenter.com/llc_advantages.html
    • ○ Disadvantages of an LLC (web site) http://www.limitedliabilitycompanycenter.com/llc_disadvantages.html
    • ○ LLC vs. S-Corp (web site) http://www.limitedliabilitycompanycenter.com/llc_vs_s_corp.html

    • ○ From IRS web site: Can I be an LLC? A Limited Liability Company (LLC) is an entity organized under the laws of a state. You must file or intend to file articles of organization with your state before you can be recognized as an LLC. There can only be one LLC with the same name in any one state.

    • ○ From IRS web site: Limited Liability Company (LLC) A limited liability company (LLC) is a structure allowed by state statute. An LLC is formed by filing articles of organization with the individual state’s secretary of state. Owners of an LLC are called members. Members may include individuals, corporations, other LLCs, and foreign entities. An LLC can be formed by one or more members, and there is no maximum number of members.

    • There can be no more than one active LLC with the same name in the same state.

    • For federal tax purposes, an LLC may be treated as a partnership or a corporation, or be disregarded as an entity separate from its owner.

    • An LLC can also be organized as a professional limited liability company (PLLC) or a limited company (LC).

    • ○ From IRS web site: Limited Liability Company – What it is…
      • ◙ A limited liability company (LLC) is a structure allowed by state statute.
      • ◙ An LLC is formed by filing articles of organization with the state’s secretary of state office.
      • ◙ An LLC must be unique in its state. There can be no more than one active LLC with the same name in the same state.
      • ◙ For federal tax purposes, an LLC may be treated as a partnership or a corporation, or be disregarded as an entity separate from its owner.
      • ◙ An LLC can have two or more members (multi-member) or one member (single-member).
      • ◙ An LLC can have an unlimited number of members.
      • ◙ An LLC’s members may include individuals, corporations, other LLCs, or foreign entities.

    What it is not…

    • ◙ LLCs are not incorporated and do not file articles of incorporation

  • Domestic B-Corporation and/or Benefits Corporation
    • ○ A B-Corporation is 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.

    • ○ 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.

  • Domestic S-Corporation
    • ○ When only one person is desired to be the owner of the entity, an S-Corp has many of the same benefits as does the Multi-Member LLC. The S-Corp is more tightly structured than the LLC which for many purposes makes it particularly less desirable than an LLC when there is more than one owner.
      • ◙ generally speaking, there is no home office deduction available when using an s-corporation.
      • ◙ generally speaking, there is no deduction for unreimbursed expenses paid out by the shareholders.
      • ◙ a separate checking account should be maintained by the s-corporation and all expenses paid from this account, or the shareholders reimbursed for any advances made on behalf of the business.

    • ○ On the other hand, an S-Corp makes for a more bullet-proof assignment of a portion of the annual trading gains into “earned income.” The shareholder(s) are able to receive W-2 wages which can clearly define the income to be used when computing your retirement plan deduction. update: Congress started looking into this in 2005.
      • ◙ It might be successfully argued by IRS that the shareholders be paid a reasonable salary, subjecting some trading gains to Social Security and Medicare tax and unemployment tax and possible disability or other employee related taxes.

    • ○ Additionally 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.

    • ○ You elect to be an S-Corp with the IRS as follows:
      • ◙ Form a corporation and immediately upon obtaining a federal id number using form SS-4, elect S-Corp status using form 2553 or…
        update: new Rev. Proc. 2007-62 (Alternative link) (Alternative link) issued in October 9, 2007 allows the S-Corp election form 2553 to be filed late – filed with the initial federal income tax return in certain circumstances.
      • ◙ Form an LLC and immediately upon obtaining a federal ID number using form SS-4, elect check-the-box corporate status using form 8832 and S-Corp status using form 2553.
        update: new IRS Regs issued in July 2004 allow LLCs to forgo filing form 8832 and rather only file form 2553 under certain circumstances. see §301.7701-3T(c)(1)(v)(C) for where form 2553 can be filed alone, see Rev. Proc. 2004-48

    • ○ Trap – Do not overlook that to elect to be an S-Corp with the State as follows:
      • ◙ New Jersey, by filing Form CBT-2553
      • ◙ New York, by filing form CT-6
        • □ New York City does not recognize the S-corp. election
      • ◙ Pennsylvania, by filing REV-1640 prior to 2006
        • □ or revoke by filing form REV-976

    • S-Corporation Checklist
      • ◙ Determine that the corporation has fewer than 75 shareholders
      • ◙ Determine that all shareholders are natural persons or estates
      • ◙ Determine that the corporation has only one class of stock issued and outstanding
      • ◙ Determine that the corporation is already incorporated in the U.S or in one of its possessions
      • ◙ Determine that the corporation hasn’t had “S” status within the past five years
      • ◙ All shareholders must consent to the election to be treated as an S-corporation
      • ◙ Notice of a special shareholders meeting for the purpose of consenting to the election as an S-corporation should be provided to all shareholders of record
      • ◙ A special shareholders meeting should be held at which all shareholders of the corporation consent to the election by the corporation to be treated as an S-corporation
      • ◙ A shareholders resolution consenting to the election to be treated as an S-corporation should be signed by all shareholders of record
      • ◙ The secretary of the corporation should complete IRS Form 2553: Election by a Small Business Corporation
      • ◙ All shareholders of record must sign IRS Form 2553: Election by a Small Business Corporation
      • ◙ The secretary of the corporation should file IRS Form 2553: Election by a Small Business Corporation

    • ○ You do not maintain an Operating Agreement, as you would with an LLC, but you do need to maintain minutes and by-laws. For many cumbersome items that would normally need to go into an LLC Operating Agreement, the S-Corp may use an employment agreement to make things easier to handle.

    • ○ Because of the numerous tricks and traps of the s-corporation, this should only be used in rare and unusual circumstances. When a solo trader has no “2nd member” to form a partnership or LLC with, a c-corp can be formed to stand in as this “2nd member.”

    • ○ A wonderful little s-corporation information web site: http://www.scorporationsexplained.com/

    • ○ From IRS web site: S Corporation Status Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation’s shareholders include their share of the corporation’s separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated income or loss.

    • ○ From IRS web site: An S corporation – What it is…
      • ◙ A corporation is a person or group of people who establish a legal entity by filing articles of incorporation with the state’s secretary of state granting it certain legal powers, rights, privileges, and liabilities.
      • ◙ An S corporation is an eligible domestic corporation that wants to avoid double taxation (once to the shareholders and again to the corporation) by electing this status using Form 2553 (Election by a Small Business Corporation).
      • Note: An S corporation can be an eligible LLC rather than an eligible domestic corporation.
      • ◙ Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income.
        What it is not…
      • ◙ An S corporation is not a sole proprietor or partnership.

  • Domestic or Out-of-State C-Corporation as a member of your LLC or Limited Partnership
    • ○ When a member of your LLC is a C-Corporation you can run your medical and health expenses through it as a non-taxable employee benefit. Also you might qualify for a 100% deductible IRC §119 mid-day meal deduction.
      • ◙ Note that the C-Corporation is a co-owner with you in yet another entity. Double the number of entities and you double your fees and red-tape. Keep that in mind before jumping into this style set-up.

    • ○ Other c-corporation fringe benefits include (if not discriminatory in nature): group term-life insurance, disability insurance, $ 5,000 death benefit, stock purchase plans, option plans, cafeteria plans, child care plans, employer provided housing an meals. Also non-qualified deferred compensation plans – are available to c-corporations enabling them to provide non-tax deductible contributions to a non-qualified plan (on a discriminating basis), with tax deferred benefits to the company executives.
    • ○ When a member of your LLC is an Out-of-State C-Corporation, legitimately domiciled and operated in Nevada for example, you can allocate a portion of your income to Nevada where there is no State income tax and where the IRS might tax the gains at the lower 15% tax rate.
      • ◙ ote we said “might” tax the gains at the lower 15% tax rate. This presumes that the corp is not classified as a personal service company earning revenues from activity involving the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
      • ◙ or that you have more than one C-Corporation, which are classified as a “controlled group” which can result in forgoing the 15% tax rate.
      • ◙ r where you have accumulated gains and profits without having paid out taxable dividends (subject to double taxation) otherwise being subjected to the “accumulated earning tax.” Or being forced to lower the accumulated earnings by declaring wage-bonuses subject to employment taxes, unemployment taxes and sometimes other red tape issues with the State Labor Departments and Disability Insurance authorities and other compliance issues and potential penalties for not filing any of a number of additional tax forms.
      • ◙ or where the corporation is treated as a “personal holding company” because roughly 60% or more of the annual income comes from dividends and interest or a few other items.
      • ◙ a point here. We’ve seen on the internet an “expert” claiming that our cautionary statement here is an “odd practice” -“We say odd because traders by definition are not subject to the personal holding company tax, regardless of their choice of corporate entity.” [emphasis added]. And of course that is the case if your definition is that year-after-year your trading gains or other income will always be high enough so that your dividends and interest income never exceed 60% and that the IRS will never challenge your “definition” that you are a trader.

      • ○ Many traders have periods where they might slow down. Perhaps their volume is too low for the IRS’s liking and then what if trader status is challenged? What better incentive to leave on a red carpet for the IRS but a potential “personal holding company” assessment? Or what if the trading results in a small loss, with the result that dividends and interest exceed 60% of income? Why take chances? There’s no good reason to in our opinion, when with a little professional foresight it can be done with appropriate safeguards in place. Proper tax planning thinks ahead several steps and hopefully does not risk a total and irretrievable meltdown if the first line of defense fails.
        • ◙ Note that we also said “legitimately domiciled and operated.” There are vendors out there mass-marketing a “C-Corp solution” to taxpayers residing in high-tax States, particularly to those living in California. We have seen many of these setups were the taxpayer was charged thousands of dollars in consulting, planning and incorporation fees where the tax and legal benefits were overstated.
        • ◙ You cannot trade from California through a registered Nevada C-Corp and legally avoid all California State taxes on your earnings – due to the concept of taxation called “nexus” (for more information, search for “nexus” on this page: A Trader’s Choice of Entities )
        • ◙ You can allocate a reasonable portion of your income to Nevada, if you properly structure and segregate the business activities of each entity. But unless you change your State of residence to Nevada, and perform your work in Nevada, then you will not necessarily be able to legally allocate all of your income to Nevada.
        • ◙ update: recently (2005) the IRS has been attacking owners of NV entities due to the high probability that those participating in aggressive tax abuse schemes have established a NV entity under the direction of Tax Fraud Promoters who are under observation due to the stepped-up enforcement in that area by the US Gov’t. Sure, NV may promise secrecy – but when the IRS is threatening you with obscure fines of up to $10,000 for each tax form allegedly misfiled and for each allegedly required tax form not filed unless you cooperate fully by disclosing everything regarding your finances and investments, everything you know about the promoters and about all the people you know – well you get the picture, NV “secrecy” is a mere joke unless perhaps you have a team of high-power lawyers representing you.
        • ◙ update: So-called Nevada secrecy was dealt a strong blow by the Court: (Martini v. US district of Nevada 5/10/2006). IRS summons to get secret taxpayer information is enforceable.
        • ◙ We feel that for most traders this is too costly and has extra red tape that outweighs the potential tax savings – but on the other hand, in special circumstances, there are many consistently profitable traders who use this type of multiple-entity set-up to their advantage.

  • Family General Partnership (FGP)
    • ○ Less formal, easy and less expensive to form and offering many of the same features as an LLC taxed as a partnership.
    • ○ Partners must number two or more and may include, for example: husband, wife, child (caution if less than two members are of legal age), other friend or relative, a corporation, a LLC, an estate or a trust.
    • ○ The FGP offers no liability protection at all. All FGP assets are at risk by the actions of any partner.
    • ○ We recently saw a newsletter sent to traders mentioning this concept with a husband & wife JTWROS account as their so-called new “idea.” But bear in mind that family partnerships have been around for a long time. We have been putting clients into family partnerships including husband/wife partnerships, the correct way, for decades. Do not be concerned that this is some “new” unproven scheme. A partnership comprised solely of a domestic couple is nothing new to tax advisor’s or to the IRS. They have been a proven method of doing business and filing taxes for decades.
    • ○ The concept of bona-fide family partnerships has been mentioned for free on this web site since it was first established in 1999, after the “new entity rule” was established by Rev. Proc. 99-17. So this can hardly be thought of as a new “idea” even for traders – but be aware that experience has shown that when the owners are solely a husband and wife (or other domestic couple) care must be taken to qualify under IRC Code §6231(a) and §761. The mere co-ownership of assets does not qualify under scrutiny. Regs. §§1.761-1(a), 301.7701-1(a)(2). While we have been doing bona-fide family partnerships for traders since 1999 and for other taxpayers for many, many years prior to that, this is not necessarily preferable to the other entity structures listed above.
    • ○ Regardless, it is inappropriate to flaunt something implying that it is somehow an underhanded tax-motivated scheme. Substance over form and taxpayer intent go a long way in establishing credibility with the IRS. In all cases, the family partnership must be a bona-fide economic, business-like arrangement. These should be handled on a one-on-one basis, not some mass-marketing cookie cutter approach that is sure to peak the interest of the IRS once they think they smell a tax cheat.
    • ○ You may optionally choose to maintain a Partnership Agreement.
    • ○ The general partnership can be preferable when non-active owners are partners in the entity which trades commodities (futures) – if more than 35% of the ownership interest is held by the non-active partners. See limited entrepreneur.

  • Family Limited Partnership (FLP)
    • ○ More formal, difficult and more expensive to form than a LLC or a FGP. These have similar tax attributes with added features that are useful for asset protection plans and valuation discounts related to family gifting estate plans.
    • ○ Usually used by wealthy, solidly successful, somewhat more mature traders with children as part of their estate planning.

  • Domestic or Out-of-State Single-Member Limited Liability Company (SMLLC)
    • ○ A SMLLC may be owned, for example, by one individual, by one LLC or by one corporation.
    • ○ This specialized entity might be used for somewhat limited asset protection, SEC rule work-arounds, to definitively segregate some trading activity from other activities and for other purposes that need a separate legal entity for non-tax purposes. The SMLLC is disregarded by the IRS for tax purposes unless it files the appropriate election to not be a disregarded entity on form 8832. In that case the SMLLC would be taxed as a C-Corp or if form 2553 is also filed, as an S-Corp. (In certain cases, under §301.7701-3T(c)(1)(v)(C) form 2553 can be filed alone, see Rev. Proc. 2004-48 and Rev. Proc. 2007-62 )
    • ○ If form 8832 and/or form 2553 are not filed the entity generally is disregarded for all tax purposes and elections as an entity separate from its owner. It is treated under the IRS regulations as an “Alter-Ego entity.” Alter-Ego theory also allows the IRS to undo many “creative” but ineffectively designed tax-motivated schemes using corporations, trusts or SMLLCs. It is simply foolish to try any “creative” games using a disregarded SMLLC when all such problems and concerns can be avoided with a multi-member LLC or S-Corp.
    • ○ Even if disregarded, a SMLLC owned by an individual (rather than by an entity) may create earned income for a trader’s spouse by paying a salary or fee for services rendered by the spouse. Of course a similar result could be accomplished without the bother of using a SMLLC. (since a SMLLC is disregarded by the IRS anyway)
    • ○ Other entities that are disregarded as taxable entities from their owners including: Qualified Real Estate Investment Trust Subsidiaries (QRSs), Qualified Subchapter S Subsidiaries (QSubs) and Single Owner Eligible Entities should be avoided for trader status strategies.
    • ○ Under §301.7701-3(b)(1) and (2), an eligible entity with a single owner may be disregarded as an entity separate from its owner. Section 301.7701-3(b)(1)(ii) provides that a domestic eligible entity with a single owner is disregarded unless the entity makes an election to be classified as an association (and thus a corporation under §301.7701-2(b)(2)). Section 301.7701-3(b)(2)(C) provides that a foreign eligible entity with a single owner that does not have limited liability is disregarded unless the entity elects to be classified as a corporation. Under §301.7701-3(c), a single owner eligible entity that has elected to be treated as a corporation and a foreign eligible entity with a single owner that has limited liability (that would otherwise be treated as a corporation under §301.7701-3(b)(2)(i)(B)) may elect, subject to certain limitations, to be disregarded.

  • Limited Liability Limited Partnership (LLLP) & Family Limited Liability Limited Partnership (FLLLP)
    • ○ The new kid on the block, the LLLP form of entity offers stronger asset protection compared to the LLC.

  • Separately Managed Accounts (SMA)
    • ○ Friends & Family (generally 15 or fewer clients)
    • ○ While this is a popular method for many advisors, the use of a SMA set-up alone is often a very tax inefficient way to go. Saving less than a thousand dollars a year (slightly more in some situations – CA registered entities, most notably) can cost your investors a meaningfully tax write-off for your fees, and can result in your fees being subject to double federal taxation (federal income tax as well as self-employment taxes). SMA’s generally are prohibited from electing Mark-to-Market, whereas with a proper entity selection this is yet one more benefit for your investors.
    • http://www.interactivebrokers.com/en/accounts/advisors/advisorsMain.php
    • ○ often SEC and State Blue Sky registration issues are relaxed when a proper relationship, including a separately filing trading entity, is created. http://www.interactivebrokers.com/en/accounts/advisors/regulatroyRegistration.php?ib_entity=llc

Trader tax return statistics:

IRS SOI Tax Stats – Historical Data Tables

IRS Tax Statistics

From IRS website:
Question: Can you give me plain English definitions for the following: (1) a closely held corporation, (2) a personal holding corporation, and (3) a personal service corporation?

Answer: Generally, a closely held corporation is a corporation that:

  • Has more than 50% of the value of its outstanding stock owned (directly or indirectly) by 5 or fewer individuals at any time during the last half of the tax year; and
  • Is not a personal service corporation.

The definitions for the terms “directly or indirectly” and “individual” are in Publication 542, Corporations.

A closely held corporation is subject to additional limitations in the tax treatment of items such as passive activity losses, at-risk rules and compensation paid to corporate officers.

A personal holding company:

A corporation will be considered a personal holding company if it meets both the Income Test and the Stock Ownership Test.

  • The Income Test states that at least 60% of the corporation’s adjusted ordinary gross income for the tax year is from dividends, interest, rent, royalties and annuities.
  • The Stock Ownership Test states that at any time during the last half of the tax year, 5 or fewer individuals must directly or indirectly own more than 50% in value of the corporation’s outstanding stock.

Refer to the Instructions for Schedule PH (Form 1120) (.pdf), U.S. Personal Holding Company (PHC) Tax, for more information and a list of exceptions.

A personal service corporation:

  • Its principal activity is performing personal services during the “testing period.”
  • Its employee-owners substantially perform the services. A corporation meets this requirement if more than 20% of the corporation’s compensation cost for its activities of performing personal services is for personal services its employee-owners perform during the testing period.
  • Its employee-owners own more than 10% of the fair market value of its outstanding stock.
  • Personal services include, but are not limited to, any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law firms and the performing arts.

Generally, the testing period for any tax year is the prior tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of:

A. The last day of its tax year, or
B. The last day of the calendar year in which its tax year begins.