Why Form an Entity?

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

THE REASONS TO FORM YOUR OWN ENTITY:
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As a trader you need to form a separate trading entity for the following reasons:

  • For a situation where the individual might not (or cannot) be treated as “a trader” by the IRS because she earns a living from activities in addition to her trading activities, such as:
    • ○ receiving income from a full-time W-2 wage job
      • ◙ recently we’ve seen several self-prepared returns where the unwavering pre-audit IRS position is that any W-2 received by either spouse negates their ability to be treated as a securities trader or commodities trader.
    • ○ earning dividend and interest income
    • ○ having (other business) self-employment earnings
    • ○ … or any SMLLC business activity
    • ○ receiving income or loss from an active pass-thru entity activity
    • ○ receiving income or loss from passive pass-thru entity investments
    • ○ holding substantial investments of any kind
    • ○ being supported in a way other than from active trading
    • ○ having a primary source of income other than active trading
    • ○ earning a living in any other way, besides active trading

    then a 100% pure-play trading entity can be set up and the entity itself will be the trader as 100% of its activities and 100% of its capital are employed in an active business of trading.

  • It can be said that a better rule of thumb is to only claim trader status as an individual, reporting income on tax form 1040, whenever the activity is your only “job” and you have no other funds available to support yourself with. Otherwise, consider forming a separately filing entity that will not use Form 1040.

  • When your job is in the securities industry (stock brokers, financial investment advisors, registered reps, etc. ), often your purchases and sales need to monitored or reported to and approved by your employer’s compliance department. Investing your funds one time into a separate entity where it is the entity that will be doing the actual trading, in some situations, can eliminate this need to go to your compliance department and disclose details regarding every transaction.

  • Virtually every retail broker automatically treats a LLC or other entity as a “professional user” by default. There must be a reason! LLC’s and other entities command respect, they show that you mean business, are serious about your trading and are a professional. When seeking the best and largest tax deductions, having an entity in your corner can only help.

  • For more sophisticated mark-to-market elections and revocations:
    • ○ To facilitate a so-called “retroactive” mark-to-market election filing.
    • ○ To help facilitate a so-called “retroactive revocation” of the mark-to-market election.
    • ○ To allow an easy and permanent proactive revocation of a mark-to-market election, simply by stopping the use of the entity, rather than incurring the time and expense and uncertainty of filing a request to revoke.
    • ○ To isolate and protect an individual who has a large capital loss carry-forward from a prior tax year.
    • ○ As “insurance” to temporarily elect mark-to-market for commodities (futures) trading during a potential isolated loss year, so that you will retain the special lower “60/40” tax rate for use in a profitable year, without having to file a request to revoke with the time and expense and uncertainty associated with that.

  • Unlike individual taxpayers filing Form 1040, certain entities (such as those filing tax Forms 1065 and 1120S) are exempt from the rule that each sale be listed on the tax return (Downloaded info, Excel spreadsheet, Quicken report, Broker provided gain/loss report, etc.)
    • ○ Starting with 2013 the requirement for a detail listing on Form 8949 / support statement was canceled for certain situations were the broker reported the gain or loss to the IRS and if there were no wash sales or other adjustments.
    • ○ Individual tax Form 4797, used by M2M traders, requires the use of a free-form statement in the same format as a Schedule D.
    • ○ Entity tax returns using Schedule D require the use of a free-form statement in the same format as a Schedule D.
      • ◙ Starting with 2013 the requirement for a detail listing on Form 8949 / support statement was canceled for certain situations were the broker reported the gain or loss to the IRS and if there were no wash sales or other adjustments
    • ○ Entity tax returns using Form 4797 for M2M traders may require the use of a free-form statement in the same format as a Schedule D.

  • To qualify for and obtain more tax deductions!!
    (if you read elsewhere that sole-proprietor traders are allowed al! the same tax deductions as an entity-based trader, perhaps you need to keep reading and learn the correct facts):

    • ○ health insurance (though, a sole-proprietor trader can arrange to have this deduction by paying the spouse an appropriate W-2 salary and then providing all employees and their families with health insurance). Of course, the employee-spouse must be a bona fide employee (T.C. Memo. 2007-351) paid for personal services actually rendered to the business.
    • ○ self-insured medical reimbursement plan (see spouse trick above)
    • ○ disability insurance deduction
    • ○ de minimis fringe benefits and occasional supper money Regs. §1.132-7(a)(2)
    • gym and athletic facilities, including tennis courts, swimming pools and exercise equipment (see spouse trick above)
    • ○ no interest or low interest loans
    • ○ company purchase of home, when a loss makes selling expenses non-deductible (see spouse trick above)
    • ○ tax-free transportation, limos and chauffeurs
    • ○ free parking, vanpools and transit passes (this is not deductible for 2% or more s-corp shareholders)
    • ○ tax-free lodging (Rowan Companies, Inc. v. United States, 101 S. Ct. 2288 (1981), Ct. D. 2009, 1981-2 C.B. 191)
    • ○ tax-free meals, including meals furnished because all employees must be available during lunch for emergencies (Boyd Gaming, 106 TC No. 19 and IRC §274(n)(2)(B))
      • ◙ note that per McDowell v. Commissioner, T.C. Memo. 1974-72 the meals and lodging must be furnished by the entity. Reimbursing the employee for receipts submitted will not qualify as tax-free
    • ○ retirement plans (because of the IRS Code that prohibits sole proprietorship traders from contributing)

    the above list is mostly “courtesy” of Sandy Botkin, CPA (see page 175 of his book advertised on Amazon)

  • To lower your risk of being selected for IRS audit.
    • ○ The IRS has obsolete computer systems, including magnetic tapes and 70 different operating systems. With what little they have to work with, they must concentrate on the individual Form 1040, where most non-compliance issues are found.

  • To lower your risk so that, if selected for IRS audit, your trader status tax position will be more likely to stand up against IRS attack.
    • ○ Business entities are assigned to the more experienced field auditors who are savvy enough to understand a business-person’s perspective.
    • ○ Often, the tax Form 1040 is assigned to a less-experienced office audit examiner who starts off assuming the taxpayer is guilty of some level of underpaying his taxes.
    • ○ The overwhelming majority of trader status cases that go to Tax Court are those of Individuals filing as a Sole Proprietorship on a Schedule C. Few cases come to Tax Court for trader status with an entity that files a separate tax return, and of those cases, many are egregious with multiple infractions besides a questionable claim of trader status.
    • ○ The majority of trader status cases that go to Tax Court for Individuals filing as a Sole Proprietorship on a Schedule C result with a win for the IRS.

  • To lower the chances of any issues arising under the IRC §469 Passive Activity and Material Participation Rules as concluded by the U.S. Supreme Court in Groetzinger.
    • IRS Regs 1.469-1T(e)(6) (alt link CCA200111001) state that when a properly setup partnership or LLC is a trader, the §469 Passive Activity Rules for the most part do not apply to the owners. IRS Regs §1.469-1T(e)(6)(iii)
    • ○ It should be noted that generally the §469 Passive Activity Rules continue to not apply to the owners even if trader status is not upheld. IRS Regs §1.469-1T(e)(6)(I)
    • ○ Amazingly, an identical management/profit sharing arrangement except without a properly organized separate entity (which is common with “managed accounts”) results in very different and unfavorable taxes for both the investor and for the trading manager.
      • ◙ IRS Chief Counsel, in 2007, has reiterated this position. CCA200721015 states that under IRS Regs §1.266-1(b)(1)(iv) a flat fee paid to a stockbroker for investment services is an itemized deduction and is not a “carrying charge.”

  • This next item regarding Form 1099-B is fairly obsolete since 2011:
    Corporations generally do not have a Form 1099-B sent to the IRS reporting their activity. This lack of a 1099-B matching program lowers the exposure of a c-corporation’s tax return to IRS scrutiny.  But it is generally foolhardy to use a C-corporation for the trading entity.

    • ○ Conversely the lack of a 1099-B to tie in to requires that your own internal recording keeping needs to be maintained at a higher level to make sure your numbers are accurate.
    • ○ Many S-corporations have started to receive Form 1099-Bs starting in 2011.
    • ○ Brokerage accounts with a customer name that contains the term “insurance company,” “indemnity company,” “reinsurance company,” or “assurance company” generally do not receive a 1099-B.

  • To allow Income Shifting or Income Splitting.
    • ○ If you have significant trading gains this can allow you to shift a portion of that income from your highest income tax brackets, for example, to the lower tax brackets of your children.
    • ○ If you want to trade the funds for other family members or friends – the tax deductions they receive for your compensation generally can be structured to be fully deductible for federal & state purposes, rather than being limited as with typical “full discretion managed accounts.”
    • ○ Many other beneficial, “special allocations having substantial economic effect under the §704(b) regulations.” (Allocations of partnership items are permitted only if these allocations are agreed upon in the partnership agreement)

      • §1.704-1(b)(2) has three requirements based on the principles contained in paragraph §1.704-1(b)(2)(ii)(a) and except as otherwise provided in §1.704-1, an allocation of income, gain, loss, or deduction (or item thereof) to a partner will have economic effect if, and only if, throughout the full term of the partnership, the partnership agreement provides–
        • □ 1.704-1(b)(2)(ii)(b)(1) For the determination and maintenance of the partners’ capital accounts in accordance with the rules of paragraph (b)(2)(iv) of this section,
        • □ 1.704-1(b)(2)(ii)(b)(2) Upon liquidation of the partnership (or any partner’s interest in the partnership), liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (2) and requirement (3) of this paragraph (b)(2)(ii)(b)), by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), and
        • □ 1.704-1(b)(2)(ii)(b)(3) If such partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (3)), he is unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances (in accordance with requirement (2) of this paragraph (b)(2)(ii)(b)).

  • Good way to allow you the ability to create “earned income” and thereby make tax deductible retirement plan contributions of $60,000+ each for yourself and for family members, including young children.
    • ○ Keep in mind that “earned income” is subject to Social Security taxes of 15.3% on the first $120,000 (or so) per year, per person and 2.9% or 3.8% on amounts over that.

  • Allows traders with AGI greater than $250,000 who have significant trading gains (in excess of $250,000 per year), being able to convert 3.8% of Net Investment Income Tax (Obamacare tax) gains into approximately 3.5% Self-Employment, Medicare, Social Security Tax “earned income.”  This also results in a larger “above the line” deduction for 50% of self-employment tax.  Changing gains in this manner from being subject to Net Investment Income Tax results in lower taxes for the year.
  • The “earned income” also allows the possibility of deducting 100% of your family’s health insurance.

  • The “earned income” also allows the possibility of deducting your family’s medical & health expenses, if a c-corporation is formed.
    • Note though, the “earned income” method can also be used to hire your spouse to legitimately perform viable services to a non-c-corporation business, including a self-employed business – a sole proprietorship securities trader.

  • To allow you to deduct a higher meals expense allowance, if a c-corporation is formed.

  • To provide some level of asset protection against “charging orders” should you have a judgment rendered against you for some non-trader reason, if a multi-member LLC is formed.

  • To lower or eliminate, to a limited extent, the IRS and State taxes for any income allocated to an out-of-State c-corporation (using a multi-entity set-up).
    • ○ The c-corporation tax rate is 15% on the first $50,000 of taxable income per year, limited to an accumulation over several years of up to $250,000 (or even $150,000). Further subject to any limitations applicable to personal holding companies (PHC).

  • Be aware that an entity often has higher fees charged by the brokerage and to obtain real-time quote services. (at many brokerages, with a little foresight, it often is easy enough to avoid these higher fees)
    • ○ On the other hand some brokerages charge less for entity accounts, IB for example.

  • Obtaining credit, opening a bank account, opening a brokerage account, trading options and futures and obtaining margin may entail more red-tape when working through an entity. (again, with a little foresight, it often is easy enough to work around these problems)

  • Of course, when business assets become large, I am a big believer in not putting all of your eggs in one basket. Consider using multiple entities at the same and in staggered levels of ownership to help reduce your tax burdens, as well as the inevitable liability and lawsuit exposure that success brings. These can include an assortment of C and S corps, as well as LLCs, LLLPs and trusts.

  • Here’s a nice 167 page booklet (PDF file) entitled “Incorporate The Road To Riches” that reinforces many of the above reasons, and adds several more in an easy to read format.

  • This web page link explain more reasons to for a separate entity: “Protect Your Business Losses by Incorporating

Clarification needed:
Some information can be found on the internet that purportedly offers to save taxpayers money by having them form a type of entity for traders that does not need to file a separate tax return, and thereby you have lower tax preparation fees if you use these preparers. Unfortunately for taxpayers who follow that line of thinking, it turns out to be more hype than it is substance.

The fact here is that it is not the “separate entity” alone that creates the “magic” discussed on this webpage. Rather, it is a separately filed tax return in addition to your own personal tax Form 1040 that results in the tax benefits.

And how does one file a separate tax return? One forms a type of entity that is required to file a separate tax return!

DISCLAIMER:
Nothing here on this webpage, on the TraderStatus.com web site or in the accounting practice of Colin M. Cody, CPA, CMA comes even close to being construed to be a “so called” IRC §6700 activity or transaction. It is improper to secure any tax benefit by reason of holding an interest in an entity or participating in a plan or arrangement which the person knows or has reason to know is false or fraudulent as to any material matter. Only legitimate business traders having legitimate business purposes (as described above) for using an entity are welcomed here. Please click this link for a zillion more required disclaimers <- please note that this is prominently disclosed, as required by law.