• For a situation where the individual might not (or can not) be treated as "a trader" by the IRS because he or 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 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 form a separately filing entity that will not use form 1040
   
• 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" 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.
  • 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.
     
• Unlike individual taxpayers filing form 1040, all entities (such as those filing tax forms 1065 and 1120S) are clearly exempt from the new 2005 rule (temporarily retracted in January 2006) that each sale be listed directly on an  IRS Schedule D-1 (see 2005 instructions page D-6) rather than attaching a supporting statement to the tax return (Quicken report, Excel, Broker provided report, etc.)
  • Individual tax form 1040 has the Schedule D-1 to be used with the requirements found in the 2005 instructions
  • 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.
  • Entity tax returns using form 4797 for M2M traders 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 for 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)
  • 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 also not deductible with 20% 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 elsewhere on this web page)
   

• 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) 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."
       
• Corporations generally do not have a form 1099 sent to the IRS reporting their activity.  This lack of a 1099 matching program lowers the exposure of your corporation's tax return to IRS scrutiny.
  • Conversely the lack of a 1099 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.
    
    
• To allow Income Shifting or Income Splitting.
  • If you had 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,z 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 $44,000+ 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 $100,000 (or so) per year, per person and 2.9% on amounts over that.
     
• 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 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" that creates the "magic" discussed on this web-page.  Rather, it is a separately filed tax return in addition to your 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 web page, 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.

THE TYPES OF ENTITIES:
Some types of entities 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 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
    
• 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.
     
  • 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.
     
  • 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.
    
     
• 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 would tax the gains at the 15% tax rate.
    • Note we 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 benefits were overstated.
    • You can not trade from California through a registered Nevada C-Corp and legally avoid all California State taxes - 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 legally be able to 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 there are many profitable traders who do have this type of multiple-entity set-up.
       
• 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
    
     

BEFORE USING AN ENTITY:
Most traders start out as individual sole proprietorships (form 1040 Schedule C).  Some observations regarding Schedule C:

• If mark-to-market is desired, generally you must notify IRS that you elect in advance of filing your tax return - sent via certified mail between the dates of January 1 and April 15 of the year that mark-to-market is to begin. 
  • This is more cumbersome than a separate newly formed entity which elects mark-to-market when it is formed or when operations begin, but does not actually notify IRS until its first separate tax return is filed.
  • Note that SMLLCs generally do not file their own separate tax returns, therefore making a retroactive election under the guise of a newly formed SMLLC is foolhardy at best.
     
• Mark-to-market is a permanent election.  To drop the election you need to secure the written permission from the IRS Commissioner.  It is not clear if mere changing or closing the trading business or trading account has any ability to revoke the mark-to-market election.
   
• IRS audits are primarily targeted at individuals (form 1040), and among individuals they are more specifically targeted at those filing Schedule C and showing a loss.
  • Traders, by definition, show a loss on Schedule C.  That's where your expenses are deducted, whereas your trading gains are reported on Schedule D or Form 4797.
  • It is improper for a trader to reclassify any portion of interest income, dividend income, trading gains or losses from Schedule B,  Schedule D or Form 4797 to Schedule C to obfuscate the Schedule C loss.  By law, only a Securities Dealer is allowed (is required) to report gains and losses on Schedule C.
    • Taking this improper position could result in an underpayment or overpayment of tax, but often this is not too serious an amount for IRS and State tax  purposes - though it can occasionally have significant implications.
    • Taking this position to obscure the proper reporting of your deductions can be a violation of IRS procedures subject to penalty (unless form 8275 or 8275-R is filed).
    • While the odds are with you against getting caught in a random audit and penalized for taking this kind of position, if you are selected for audit you run the risk of being pegged as an uncooperative adversary at worst or a poor tax preparer at best, making the audit itself more difficult to satisfactorily complete.
    • To date, over 50% of the IRS audits we've handled here (of tax returns that were initially prepared elsewhere) have been triggered specifically because the preparer reported some portion of trading gains and losses on Schedule C, and the IRS then sent the tax return to an agent/examiner to investigate.
       
• Individuals selected for audit typically find their position of trader status under scrutiny.
  • If the trader also has W-2 wages, the standard line from the IRS is that that is your gainful employment and that the trading is merely an investment activity.
  • If the trader has significant investment income, the standard line form the IRS is that your trading is merely more of the same investment activity.
  • If the trader has investment income generally a portion of his expenses need to be allocated between trading and investing.  Expenses allocated to investing are generally limited in their usefulness.

ASSET PROTECTION:
Breaking the corporate shield:

Courts have identified a fair number of instances where they will "pierce the veil" and hold the officers, shareholders or members personally liable and/or attach company and personal assets. (for clarity the words corporate, company and entity are used interchangeably in this list):

• Failure to segregate funds of separate entities.
• Commingling of company funds and other assets.
  • not properly maintaining separate bank accounts for the entity.
• Use of corporate assets for personal use.
  • using the entity's bank account "as the owner's personal checkbook."
• Absence of any major corporate assets.
• Unauthorized diversion of corporate assets.
  • failing to maintain a strong board of directors and maintaining minutes of their meetings.
  • using money for non-business purposes.
  • using money without authority as granted in the minutes or operating agreement.
• Failure to maintain arms-length transactions.
  • transactions with owners treated more preferentially than might be with 3rd parties.
  • failing to authorize loans or advances between entity and owners in the minutes or operating agreement.
  • failing to maintain written interest bearing loan agreements.
  • failing to charge and pay adequate interest on loans and advances.
  • failure to make appropriate periodic payments of interest and principal.
  • failure to pay appropriately competitive wages to the owners.
     
• Failure to adequately capitalize the corporation.
  • failure to transfer some assets into the corporation. i.e.Underfunding the corporation
  • failure to issue corporate stock or maintain corporate ledger.
  • failure to actually pay for your common stock or interest in the entity.
• Unauthorized issue or subscription of shares.
• Use of the corporation for illegal or fraudulent transactions.
   
• Meetings & Records:
  • failure to have regular board of directors' meetings.
  • failure to have annual shareholders' meetings.
  • failure to have the required initial organizational meeting.
  • failure to maintain up-to-date corporate records.
  • failure to adopt corporate by-laws.
  • failure to get the proper state and local business licenses in the name of the corporation.
• Taxes & Fees:
  • failure to pay taxes, particularly "trustee" (payroll) taxes.
  • failure to pay required Secretary of the State fees.
  • failure to file required (annual) Secretary of the State forms and fees.
     
• Failure to advertise and serve notice that the business was operating as a corporation i.e. holding yourself out as a corporation ( letterheads, etc. and always sign documents as the corporate officer, not just personally )

On March 2, 2004 the US Supreme Court decided Yates.  Dr. Yates had a corporation with employees in addition to himself and his spouse and as such under ERISA was able to protect his profit sharing plan from creditors.

On April 4, 2003 the United States Bankruptcy Court decided Albright.  Ms. Albright had a single-member LLC plan that was unable to protect assets from creditors because it was a single-member LLC.  This has no effect on liability shields

On January 13, 2005 the United States Bankruptcy Court decided Fiesta Investments.  This multi-member LLC was unable to protect assets from creditors because of the non-business-like manner it was run.  This has no effect on liability shields

On May 18, 2005 A United States District Court decided F.A. Littriello,.  The "corporate shield" protecting the assets of the owner was ignored by the court because this single-member LLC chose not to elect to be treated as a corporation.  Held: the debts of the SMLLC were the responsibility of the individual owner not as an agent of the SMLLC.  The court relied on Chevron  analysis and Kintner  regulations in making its final ruling.

On May 17, 2006 A United States District Court decided Townley.  Since the setting up of their separate entity and the related planning was admitted to be done for "asset protection" to protect assets from future unknown creditors, the court ruled that this was enough to prove that their actual intent was to engage in a fraudulent transfer.  The creditor (The Internal Revenue Service in this case) was given the assets to satisfy their unpaid taxes.




Different States offer different levels of Asset Protection.  See discussion on Choosing a State to form in.

Also see "charging orders"


 A Traders Tax Responsibilities



Colin M. Cody, CPA, CMA
TraderStatus.com LLC
6004 Main Street
Trumbull, Connecticut 06611-2400

(203) 268-7000



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