Proprietary Trading

Proprietary trading offers much greater leverage; just be aware of different tax rules that apply.

Proprietary traders are significantly different from retail traders and have special legal, regulatory, business and tax compliance needs. Proprietary traders don’t trade their own capital. They trade the firm’s capital, usually accessed from a sub-trading account within the firm. A prop trader becomes associated with a prop-trading firm either as an LLC member (Schedule K-1), an independent contractor (1099-Misc) or an employee (W-2).

If you fall in the prop trader category, here’s what you need to know.

Independent contractors

Profitable independent contractor (IC) proprietary traders receive a 1099-Misc. for “non-employee compensation.” Sole proprietors use a Schedule C to report fee revenue and deduct their business expenses, including home-office deductions, if they qualify. Schedule C net income is subject to federal and state income taxes. That net income is deemed “earned income” subject to the self-employment (SE) tax and it allows for AGI-deductions including health insurance and retirement plan contributions. Firms don’t issue 1099-Misc. to losing IC traders, since they don’t pay those traders a fee. Losing IC traders are still working, so they’re entitled to file a Schedule C, which reports expenses only.

Constructive receipt of income

Reinvesting earnings are taxable income: Prop traders generate trading gains on their sub-trading account. At the end of a defined period, usually monthly, the firm presents them with a choice: Request a fee payment (distribution of earnings) or reinvest income in their sub-trading account.Some prop firms only include fee payments on annual tax form 1099-Misc. They don’t include reinvested earnings. That’s a problem.

LLC members

LLC prop traders don’t have earned income reported on their Schedule K-1s, so they save SE tax but can’t contribute to a retirement plan or deduct self-employed health-insurance premiums. (One exception: A prop trading firm that trades futures as a full-scale member of a futures or options exchange per Section 1402i.)  Trading gains on Schedule K-1 are considered net investment income (NII) under Obamacare NIT.

Schedule K-1 line one is for ordinary income or loss. Most prop trading firms elect Section 475 MTM for securities, so the income is considered ordinary. Other firms pass through capital gains and losses and Section 1256 futures or Section 988 forex income too. The firm qualifies for TTS on the entity level, and it passes it to you on the K-1 with business expense treatment.

These LLC members also don’t file a Schedule C, as they don’t have their own business. They’re members of a trading firm that reports the business trading activity on a Form 1065 partnership tax return. The Schedule K-1 reports the trader’s share of the firm’s activity — trading gains and expenses they generated — in summary form by tax treatment. Some prop trading firms have an “accountable reimbursement plan” that the prop trader needs to “use it or lose it” before year-end. If your firm doesn’t have such a plan, then you can deduct your trading business expenses outside of the firm, including your home office, as Unreimbursed Partnership Expenses (UPE), providing the LLC operating agreement provides for UPE.

Deposits

A key tax issue prop traders face is when to write off deposits lost within the firm. Prop firms rarely account for deposits on Form 1099-Misc. When an IC prop trader loses a deposit, they can deduct a business bad debt on Schedule C, as another ordinary and necessary trade or business expense. If an LLC-member prop trader loses a deposit, they deduct the deposit as UPE on Schedule E. Many firms are lax in reporting deposit losses. Consult a prop trader tax expert.

For more in-depth information on proprietary trading, read Green’s 2017 Trader Tax Guide.

 

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