Conducting your trading business in a entity unlocks several additional tax benefits.
Forming an entity can save active traders significant taxes. Business traders solidify trader tax status (TTS), unlock employee-benefit deductions, gain flexibility with a Section 475 election and revocation and limit wash-sale losses with individual and IRA accounts. Active investors can limit wash-sale losses calculated between their individual taxable investment accounts and IRAs with an entity account. For many active traders, an entity solution generates tax savings in excess of entity formation and compliance costs.
It looks better to the IRS
An entity return consolidates your trading activity on a pass-through tax return (partnership Form 1065 or S-Corp 1120-S), making life easier for you, your accountant and the IRS. It’s important to segregate investments from business trading when claiming TTS, and an entity is most useful in that regard. It’s simple and inexpensive to set up and operate.
Section 475 MTM flexibility
Entities help traders elect Section 475 MTM (ordinary-loss treatment) later in the tax year — within 75 days of inception — if they missed the individual MTM election deadline on April 15. And it’s easier for an entity to exit TTS and revoke Section 475 MTM than it is for a sole proprietor. It’s more convenient for a new entity to adopt Section 475 MTM internally from inception, as opposed to an existing taxpayer who must prepare and file a complex Form 3115 after filing an external election with the IRS.
We recommend pass-through entities for traders. A pass-through entity means the entity is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their individual tax returns. Consider marriage, state residence and state tax rules including annual reports, minimum taxes, franchise taxes and more when setting up your entity. Report all entity trading gains, losses and expenses on the entity tax return and issue a Schedule K-1 to each owner for their respective share — on which income retains its character. For example, the entity can pass through capital gains to utilize individual capital loss carryovers. Or the entity can pass through Section 475 MTM ordinary losses to comprise an individual net operating loss (NOL) carryback for immediate refund.
An S-Corp unlocks employee benefits; a partnership does not
Choose between a partnership vs. an S-Corp tax return.
The default tax treatment for a spousal Limited Liability Company (LLC) is a partnership tax return, and for a single-member LLC (SMLLC) it’s a “disregarded entity,” a “tax nothing” in the eyes of the IRS. That means an individual-owned SMLLC, qualifying for TTS, is back to filing a Schedule C, which a business trader tries to avoid.
A multi-member LLC and a SMLLC can elect S-Corp tax treatment within 75 days of inception, or by March 15 of the current tax year for existing entities. I recommend the S-Corp election so traders with TTS can arrange employee-benefit plan deductions.
C-Corps may also elect S-Corp status. In states that have some fees applicable to LLCs, I recommend a corporation to S-Corp route. (California has LLC user fees, and New York has an LLC publishing requirement.)
A general partnership does not have liability protection and it can also elect S-Corp status in every state except Connecticut, the District of Columbia, Michigan, New Hampshire, New Jersey and Tennessee.
For more in-depth information on entity solutions for traders, read Green’s 2017 Trader Tax Guide.
Consider our entity formation service.