February 2010

Dangerous entity scams targeting traders, part 2: Are trading education, seminars and travel expenses tax deductible?

February 27, 2010 | By: Robert A. Green, CPA

A big way promoters target traders inappropriately is by promising full business-tax deduction treatment for trading education, seminars and travel expenses incurred up to 18 months before as well as after traders enter a trading entity, even if the entity doesn’t qualify for trader tax status.

This promise is very attractive to traders since many pay $5,000 to $25,000 or more for education, training and seminars before they qualify for trader tax status business treatment. 

Unfortunately, the promoters are wrong on a number of levels. We wish they were right as it would save traders lots in taxes. But, by following this incorrect advice, traders can wind up owing the IRS significant back taxes, interest and substantial understatement (higher) tax penalties. 

“Dangerous entity scams targeting traders, part 1” explained that only a trading entity that qualifies for trader tax status may have business expense treatment. Business expenses may only include items incurred after the commencement of a business activity. Despite these tax rules, the promoters promise business expense treatment for pre-business education, seminar and travel costs up to 18 months back to those who don’t qualify for trader tax status.

Under limited conditions, some pre-business education expenses can be treated as Section 195 start-up costs amortized at far lower amounts than full business deductions – providing the trader qualifies for trader tax status as a sole proprietor trader or within an entity soon thereafter. This is explained in detail below. 

When a pass-through trading entity doesn’t qualify for trader tax status, the IRS considers it an “investment company.” Tax law dictates that an investment company entity or individual investor use the more restrictive Section 212 investment income and expense tax treatment. 

The education, convention, seminar and travel tax rules
Unfortunately, most trading education, convention, seminar and travel expenses are generally not allowed as Section 212 investment expenses because of IRS rules to prevent abuse on travel and entertainment-related expenses (Section 274(h)(7)). This tax fact was confirmed for traders in a recent landmark tax court case, Carl H. Jones, III, et al. v. Commissioner. The tax court ruled that Jones, who conceded he was not a business trader, was not entitled to claim Section 212 investment expense treatment for day trading educational courses, seminars and travel expenses because those courses qualified under Section 274(h)(7). Jones wound up with no tax deduction for these items. 

Here’s a little more background information about Section 274(h)(7). 
§ 274 Disallowance of certain entertainment, etc., expenses. 
(h)(7) Seminars, etc. for section 212 purposes. No deduction shall be allowed under section 212 for expenses allocable to a convention, seminar, or similar meeting. 

Jones traveled to a destination to take a one-time course that lasted a week or more and that deduction was denied due to Section 274(h)(7). Here’s our interpretation of Section 274(h)(7) in light of the Jones decision. In-person courses lasting many weeks (rather than one-shot “seminars”), as well as online courses of any format may be considered Section 212 investment expenses – and not denied under Section 274(h)(7). 

The above non-Section 274(h)(7) courses don’t require travel to any location, and therefore ipso facto should not be governed by Section 274(h). Jones v. Comr states, “Thereafter in 1986 Congress. .. ., enacted section 274(h)(7) to curb taxpayers from claiming deductions under section 212 for expenses related to conventions, seminars, or other meetings related to financial planning. The accompanying House and Senate committee reports observed that individuals had claimed deductions for attending seminars about investments in securities or tax shelters, and that in many cases those seminars were held in locations that were attractive for vacation purposes and scheduled in ways to allow substantial recreation time. The disallowance of expenses is intended to extend to registration fees, travel, and transportation costs, and meal and lodging expenses among other costs attributable to attending a convention, seminar, similar meeting.”

If Jones had taken classes not snagged under Section 274(h)(7), he could have taken a Section 212 expense deduction because he was already an active investor and the classes helped him managed and produce investment income. 

Does the education qualify a taxpayer for a new trade or business? If so, it’s not deductible.
It’s important to note new traders may not deduct trading courses under Section 212, because they fail its main requirement: They are not already involved in Section 212 investment income generation activities before taking the trading courses. This was the problem for the Woody case discussed later: He wasn’t a real-estate investor when he took real-estate investment classes. Woody commenced a real-estate investment business activity the year after he took his non-deductible education classes, which the court said qualified him for a new trade or business.

Traders established in the business of trading under Section 162 before they take trading courses are not snagged by Section 274(h)(7), because that section limits Section 212 expenses only. 

If the education qualifies for Section 162 treatment, the business trader may take a business deduction. When an established business trader travels to attend trading courses, seminars and conventions, the travel expenses partially or fully qualify for business deduction treatment. Traders should reference specific IRS rules on travel and entertainment deductions and be aware of strict requirements on personal travel, including extending stays for personal benefit and expenses for family members.

If education courses qualifies a taxpayer for a new trade or business activity – perhaps money management for trading other people’s money which often requires various professional licenses and registrations (series 7, 3, 63, registered investment advisor, CTA or CPO) – education to achieve that professional status may be viewed by the IRS as non-deductible. The IRS usually determines the education qualifies the existing business person for a distinct, new, and different trade or business activity; in this case, professional money management vs. trader tax status for one’s own account (which doesn’t require licenses, special training, or education in advance). 

Back to the important question
Can some pre-business education, seminar, and travel costs incurred just before a trader qualifies for trader tax status be squeezed into Section 195 business start-up costs? Start-up costs are defined as investigating and inquiring about a new business, and we believe educational classes and seminars can fall in this category. 

If the answer is yes, then it’s a partial solution to the issue at hand. Section 195 start-up costs may be amortized – a tax-deduction similar to a business expenses, but far less. A maximum $5,000 first year “expense election” plus the balance can be amortized over 15 years on a straight-line basis. That’s a stretched out deduction vs. an upfront business deduction promised by promoters. 

Woody vs. Commissioner 
In Woody vs. Commissioner, the court reinforced the notion that the IRS and courts will probably deem pre-business education non-deductible for the following alternative reasons: 

1. Because the education qualifies a taxpayer for a new trade or business, which is non-deductible education.
2. Because it’s not allowed under Section 212 since the taxpayer wasn’t an existing investor at the time.
3. Because it’s allowed as Section 212 in general, but denied under Section 274(h)(7) because it involved travel. 

In post-trial briefs, Mr. Woody acknowledged that he would be precluded from the special treatment afforded under Section 195 because he failed to make the requisite election required by section 195(b). Can we infer that had Woody made the Section 195 election on time, he might have been able to use Section 195 treatment? Doubtful, since again, the court ruled that the education was non-business, and it qualified him for a new trade or business.

The Woody case states: “A taxpayer is not carrying on a trade or business under section 162(a) until the business is functioning as a going concern and performing the activities for which it was organized.” Glotv v. Commissioner, supra. Until that time, expenses related to that activity are not “ordinary and necessary” expenses currently deductible under section 162 (nor are they deductible under section 212) but are considered “start-up” or “pre-opening” expenses.

Nonetheless, in order to resolve the matter before us, we don’t need to decide whether Mr. Woody’s business started at the time he purchased the Randolph Street property or at the time he held it out for rent, because, in any event, the expenses in question all occurred before the purchase date, i.e., before Dec. 30, 2004. 9 If the earliest possible date Mr. Woody was actively carrying on a trade or business was Dec. 30, 2004, then [*16] any expenses incurred “before the day on which the active trade or business” began, sec. 195(c)(1)(A)(iii) – i.e., all the expenses incurred from Jan. 1 through Dec. 29, 2004 – would be, by definition, start-up expenses whose deductibility, and possible amortization, is expressly dealt with by section 195. Since all the expenses at issue fall between those dates, 10 they would not be deductible for 2004 under section 162 because their timing makes them subject to the provisions of section 195. (Remember, section 195 start-up expenditures are not deductible under section 162.) See Hardy v. Commissioner, 93 T.C. 684 (1989). Mr. Woody’s largest expenditure in 2004 – $ 21,515 for workshops and training – was an educational expense incurred to prepare for a new career (real estate investor and renter), rather than to maintain or improve skills in an ongoing business or career. It was therefore not deductible under section 162.”

Can Woody be interpreted in a more beneficial light for traders? 
In my view, the Woody court is saying the following: Section 162 treatment starts in 2005 and 2004 expenses may be eligible for Section 195 start-up business tax treatment. Yet, because Woody’s classes qualified him for a new trade or business (in the court’s view), the court concluded Woody couldn’t use Section 195 treatment because the business hadn’t already been in operation. 

Online traders
For online traders, typical trading education courses aren’t taken to qualify a trader for a new trade or business. Traders don’t need licenses, as is generally the case for money managers. 

Online trading is a business for which trading courses aren’t needed at all. Courses may improve a person’s skills, but many people trade without ever taking a course. This is a crucial test to get past, to avoid the Woody outcome and have a chance for including the classes in Section 195. I imagine Woody would have tried to say that his real estate classes weren’t needed for owning a rental property business. It’s a fine line of distinction.

Comparing Jones to Woody
Jones was a day trader, but didn’t achieve trader tax status, before, during, and after he took his trading classes. Jones never entered a trade or business as Woody did. 

The court claimed Jones was stuck with Section 212 and 274(h)(7) treatment, and Section 195 was not an option because he never qualified for trader tax status soon after taking his classes. Once stuck in Section 212, Jones was disallowed a deduction for the classes because the classes were snagged with Section 274(h)(7). 

Woody, on the other hand, eventually formed a new rental property business soon after taking his classes, and the court invited him to consider Section 195 for classes taken beforehand. Yet, the court ruled that Woody’s classes failed the Section 162 business test, because the education qualified Woody for a new trade or business. Jones wouldn’t have had that same problem because he was already established as an active investor; Woody was not. 

Had Jones qualified for trader tax status soon after taking his classes, he could have considered Section 195 treatment. He was already established in day trading – just not enough to qualify for trader tax status yet – and his classes in our view didn’t qualify him for a new trade or business; they continued his ongoing maintenance of trading education. 

The possible opening for traders
Traders will need to show the IRS that their courses aren’t for a new trade or business activity. Traders don’t have clients and courses don’t enhance their value to the public in anyway. As investors, traders were already engaged in short-term trading, and reaching “trader tax status,” meant they engaged in trading more frequently. This isn’t qualifying for a new trade or business for purposes of education deductions (even though it’s a new trade or business for purposes of Section 195). There is a fine line of distinction on these points, and traders should consult an expert. 

Here’s the counter argument 
The IRS may consider trading courses just like it viewed Woody’s real estate courses, concluding the trader is taking courses to be qualified for a new trade or business. After all, everyone agrees the trader has entered into a new trade or business by obtaining trader tax status (and thus qualifying under Section 195). The IRS would say the education puts an investor in the new trade or business of being a trader, and that you can’t distinguish between a new trade or business for purposes of education deductions vs. Section 195. 

Alternatively, the IRS could argue the education isn’t a Section 195 expense because it helps the trader with his current investing (and is a Section 212 deduction) even if he never qualifies for trader tax status.

Potential inconsistencies and the fine line 
Since most traders take courses that wouldn’t be deductible under Section 274(h)(7), their best shot at a tax deduction is Section 195. Better yet, qualify as a business trader before taking classes to have Section 162 expenses, unaffected entirely by Section 274(h)(7)

Traders should be careful. Some of these arguments appear to have it both ways, which could undermine a trader’s case in view of the IRS. If a trader seeks Section 212 expense treatment for continuing online classes (not travel courses), it’s hard to also argue the classes were intended to be part of Section 195 for starting up a trading business activity. 

If a trader knows his courses will be disqualified under Section 274(h)(7), or that he won’t benefit from Section 212 expenses, then it would be wiser to squeeze those courses into Section 195 start up costs. If the IRS bounces the 195 approach during an exam, it may be more difficult to claim Section 212 treatment (if not denied under Section 274(h)(7)).

Golden rules for using Section 195 
Our golden rules for Section 195 start up expense treatment for some pre-business education:

1. The amount should be reasonable and probably limited to $5,000, which happens to be the Section 195 “expense election” deduction amount, or perhaps up to $10,000. 

2. We think the look-back period should be no longer than six months and hopefully much closer to the date the trader commences his trading business with trader tax status. The business commencement date is important and the IRS rules aren’t very clear about it, so that determination is important to discuss with our professionals too. 

3. The trading education, seminars, and travel should be in connection with the trader’s original business plan.

4. Try to apportion some of the classes to investigating and inquiring (Section 195) and some to non-deductible amounts to be more conservative.

Back to the promoters promising full deductions
If you fell prey to their promises and schemes, and used business expense treatment for pre-business education, seminars, and travel expenses, you may want to consider filing amended tax returns. That may reduce IRS penalties if they catch up with you later on. 

Traders and their trader tax experts should review their files to determine if they can include any pre-business education, seminars and travel expenses as part of Section 195 start-up costs, or as part of Section 212 investment expenses. 

Bottom line
By default, pre-business education, seminars and travel are not deductible and claiming Section 195 start-up expense treatment may invite challenges from the IRS. 

Established investors may claim Section 212 investment expense treatment for online courses which aren’t otherwise denied Section 212 deduction treatment under Section 274(h)(7) ¬– otherwise known as travel seminars. 

Trader tax status is an absolute requirement (don’t be fooled by the promoters saying otherwise) for new trading businesses; there may be a narrow opportunity to squeeze some pre-business education into Section 195 start up expenses. 

When it comes to deducting pre-business education expenses, there’s still too much unknown. Our tax attorneys may be able to build a “reasonable-basis” position for your account. Perhaps they can even reach “substantial-authority” positions too. Contact us for help.


Dangerous entity scams targeting traders, part 1: Dual-entity schemes don’t deliver business treatment without qualification for trader tax status

February 15, 2010 | By: Robert A. Green, CPA

If you don’t qualify for trader tax status, don’t buy into an expensive “tax-avoidance” (perhaps illegal) entity scheme, even if the salesmen call themselves trader tax experts. Most aren’t CPAs or tax attorneys. These salesmen often pitch two types of incorrect information. 

1. An entity doesn’t need trader tax status 
Telling unsuspecting and new traders that they don’t need to qualify for trader tax status in order to arrange for and claim trader tax-related benefits within an entity structure is an incorrect statement of tax law. Trader tax status-related tax benefits include business expense deductions. New traders are particularly interested in deducting education, start-up costs, travel, seminars and home office deductions, and all those items aren’t deductible under the default investor tax status. A trader must qualify for trader tax status in an entity or as an individual to deduct these and other business deductions. 

These unscrupulous salesmen acknowledge that trader tax status is difficult to qualify for and they mistakenly — either on purpose or through ignorance — advise their potential clients to cover up non-qualification for trader tax status by organizing their trading activities within a single or dual-entity scheme, which they happen to sell for thousands of dollars. 

These salesmen’s pitch books often say “hobby loss” rules apply to traders, but that’s incorrect too. Hobby loss rules are a part of Section 469 passive-activity loss rules and under the “trading rule, ” investment and business trading companies are exempt from Section 469. 

Some salespeople have been heard to say traders need as few as 50 trades within a profitable entity to claim business expense treatment. This is entirely outside the law. Trader tax court cases such as Holsinger and Moller indicate that traders need closer to 500 round turn trades per year on a frequent, regular and consistent manner. (We offer plenty of other factors in Green’s 2010 Trader Tax Guide.

Whether a trader organizes trading activity in a sole proprietorship (unincorporated business) or within a general partnership, LLC or S-corp, the rules are the same: THE TRADER (INDIVIDUAL OR ENTITY) MUST QUALIFY FOR TRADER TAX STATUS. The IRS will probably consider this scheme a “tax avoidance” scam and take serious action against the taxpayer and the promoter. Be aware that these salesmen offer free initial consultations and tax questionnaires in order to reel in captive clients to their schemes. Perhaps these salesmen figure if they can sell a dual-entity complex structure that no other CPA will approve, they can also capture these clients for annual tax preparation, accounting and planning services. This scheme is a huge part of these salesmen’s business model. We’ve heard that some of these salesmen offer to share professional service revenues with education and seminar companies; something that’s rarely disclosed to the customer. For CPA firms, that would run afoul of CPA codes of ethics , but again most of these promoters are not CPAs and are not bound by a code of ethics. What good is an initial free consultation if it comes with bad advice that costs traders thousands in fees and causes tax trouble and expense with the IRS? Nothing comes free and if it sounds too good to be true, it’s probably false. 

Why are traders buying into this bad advice? At trade shows, conferences and educational firms, most attendees are new to trading. Most don’t qualify for trader tax status, which is getting harder to qualify for these days. We tell clients to pursue other strategies based on investor tax status and to hold off on an entity until they qualify. But that answer is not what many new traders want to hear as they want a tax deduction for their education, travel, seminars and start-up costs. That’s where these salesmen step in. They make their pitch and many traders figure it may be too good to be true, but it sounds reasonable and a firm featured at a seminar must be credible. Even if they have doubts, some traders figure they can roll the tax dice — a big mistake in our view! 

Wash sale and MTM gross misstatements of law
As part of their pitch on their Web sites and Webcasts – which we have documented – the promoters first point out that “wash sale loss” deferrals on securities are a big problem for active traders. The promoters go on to hook traders with some very dangerous misstatements of tax law in connection with wash sales and ordinary tax loss treatment.

The promoters state that individuals have great trouble qualifying for trader tax status and therefore they can’t become exempt from wash sales as individuals. They go on to say by simply setting up an entity (LLC, C-corp or dual-entity combination), the trader can skip trader tax status as a requirement within the entity and can claim exemption from wash sales and use ordinary loss treatment.

This is completely wrong and extremely dangerous. Although tax law may be somewhat vague on how to qualify for trader tax status, the law is crystal clear on wash sales and when a trader may use ordinary loss treatment.

Section 475 clearly states the only way for a trader to be exempt from wash sales and to use ordinary gain or loss treatment instead – and imputing sales on open positions at year-end – is to qualify for and properly elect Section 475(f) mark-to-market (MTM) accounting on time (usually by April 15th of the current tax year). Section 475(f) expressly states that this special tax treatment is reserved for a qualifying “dealer in securities or commodities” and was expanded in 1997 to “traders in securities or commodities.” Tax law clearly defines a “trader in securities or commodities” as an individual or entity that qualifies for trader tax status. Entities or individuals that fail trader tax status may not use Section 475 MTM, which means they are forced to report wash sales and use the restrictive capital loss treatment (not business ordinary loss treatment). This is “Trader Tax 101″ – not knowing these basics means the promoter isn’t a “trader tax expert.” As pointed out below, most hedge funds are investment companies that fail trader tax status and these hedge funds must report wash sales.

We feel very bad for the unsuspecting clients tricked by these promoters. If they get examined by the IRS – and that may happen if the IRS busts these promoters and under certain circumstances may be able to request their client lists – traders who fall short of trader tax status but used an entity to get around those rules will face thousands if not hundreds of thousands of dollars in back taxes, interest and penalties for using a tax-avoidance scheme. Traders who feel they’re in trouble here should consult a real trader tax expert and consider filing amended tax returns. That may reduce penalties. Traders who know these schemes are wrong and play the audit lottery will face very stiff penalties and tax-trouble. 

2. Dual-entity scheme with C-corp 
Sometimes salesmen offer a scheme involving a second entity (a C-corp) to traders uncomfortable with the first option above. 

The idea behind this bad idea is using a C-corp to navigate around the non-qualification for trader tax status problem. This scam is more complex and nuanced and it’s been around on the seminar circuit for over 10 years. 

Technically, a C-corp doesn’t distinguish between business (Section 162) and investment expenses (Section 212). This scheme completely fails because it’s impossible to deliver Section 162 business ordinary loss treatment to the individual owner unless the trader qualifies for trader tax status (back to the same inconvenient truth). Paying thousands of dollars for this complex and nuanced deception and tax trouble is simply not worth it. 

If you don’t think you qualify for trader tax status and you hear these pitches from salesmen, we highly recommend walking away. If you already bought into these scams, inquire about these problems in writing to these salesmen. Engage an attorney for help if needed. If you have gotten into tax trouble on these schemes by claiming business expenses when you aren’t entitled to them, we suggest filing amended tax returns. Ask these firms for your money back, too. 

The correct tax laws and reasons these scams fail 
A trading entity without trader tax status is an investment company subject to Section 212 investment income and expense tax treatment. An investment company can’t deduct Section 162 trade or business expenses. 

It’s very costly tax-wise and probably dubious to create tax-deductible retirement plans and health insurance premiums in an investment company. That’s because the earned income fee is an investment expense and the fee income is considered gross income. This raises gross and taxable income since investment expenses are often restricted, whereas with trader tax status in an entity, the gross income is unchanged. 

Adding a C-corp to the mix doesn’t work either. Losses are trapped in a C-corp and tax losses don’t flow through to a trader’s individual tax return where they can generate immediate tax benefits. 

The promoters of these schemes figure they can close the C-corps down the road and receive ordinary loss treatment at that time. They are very wrong. When closing an investment company C-corp, Section 1244 stock rules for ordinary loss treatment can’t be used because the investment company fails the gross receipts test, having portfolio rather than business income. 

If the dual-entity C-corp charges a management or administration fee to the LLC trading company, the IRS can claim that the losses show it’s a tax sham with no business purpose, since the owner of both companies arranged for the C-corp to lose money. If the LLC pays a large fee to the C-corp to be profitable, the LLC can’t deduct the fees as business expenses because it fails trader tax status, and it passes through investment expenses for the entire amount. We cover more details on these C-corp problems in Green’s 2010 Trader Tax Guide (excerpt included below). Bottom line, the C-corp can’t be used to cover up lack of trader tax status. It won’t generate business expense or ordinary loss treatment without trader tax status. 

The salesmen’s pitch books harp on “income splitting” benefits with a C-corp, as C-corps have lower tax rates on the first $50,000 of taxable income. But this doesn’t work in practice for traders, because they are subject to double federal and state taxation, which in most states makes it cost much more than a simple pass-through entity. It’s important to note that the Bush Tax cuts, including the qualifying dividend (lower long-term capital gains tax rate) expire in 2011, with the dividends tax rate returning to marginal ordinary tax rates. That 2011 tax law change will make double taxation much costlier. 

C-corps can have medical-reimbursement plans (MRPs). Partnerships and other pass-through entities may have the bigger fringe benefit plans (AGI deductions) such as retirement-plan contributions and 100 percent health-insurance premium deductions. We noticed some salesmen tell unsuspecting clients in pitch books that medical expenses are only deductible as itemized deductions in excess of 7.5 percent of AGI income, indicating it’s a big problem. The salesmen leave out the fact that health-insurance premiums are 100 percent deductible from AGI, providing a trader has earned income, which can easily be arranged with a simple pass-through entity. Most traders are reimbursed for most of their medical expenses through health insurance coverage and they wind up with few out-of-pocket medical expenses. These traders don’t need an expensive structure including a C-corp with MRP. A health savings account (HSA) with a pass-through structure can also duplicate advantages of a MRP. 

In our experience, one out of 1,000 traders may need a C-corp added to their mix. Why do these salesmen recommend that complex and costly second entity to almost every trader that they come into contact with? 

How do these salesmen respond to challenging questions? 
We’ve heard from traders who have questioned these salesmen, raising our challenges to their above strategies. These traders told us the (non-CPA) salesmen dismiss our statements as being a “difference of opinion.” In order for a taxpayer to be able to rely on advice, the advice must be considered to have “substantial authority.” Otherwise the taxpayer will be subject to penalties. It is clear to our CPAs and tax attorneys that these non-CPA salesmen’s views do not have substantial authority. We suggest asking these salesmen for substantial authority to support their strategies in writing. They would need to engage a competent tax attorney to support their frivolous positions and I highly doubt competent tax attorneys would sign a reckless opinion like this, risking their own careers.

Other resources
The sad truth: It’s harder to claim business treatment for trading than for other types of business activities. It’s wiser to deal with this reality up front than to waste thousands of dollars on foolish tax-avoidance schemes that won’t stand up to IRS exam scrutiny. 

Note that tax exams are on the rise and traders stand out like a sore thumb. In fact, when the IRS busts promoters for selling tax avoidance schemes, they often compel promoters to turn over their firm’s client lists. See several articles on the Internet about this including this one.

Our answers make sense when you look at the investment management business marketplace. Consider that hedge funds are set up as entities, yet most hedge funds don’t qualify for trader tax status (in their funds). These non-qualifying hedge funds, using leading CPA firms preparing their tax returns, issue K-1s to their investors reporting all expenses as Section 212 investment expenses, and not as Section 162 business expenses. These “investment company” hedge funds use more restrictive capital loss treatment because they aren’t entitled to elect Section 475 mark-to-market (MTM) ordinary gain or loss accounting, as that special tax election is reserved only for entities who qualify for trader tax status. 

Entire tax treatises and tax research materials prepared by leading tax publishers like CCH and RIA are titled “Investment Company” materials. This tax research addresses the key differences between section 212 investment income and expenses vs. Section 162 ordinary and necessary business treatment. 

IRS Publication 550 for Investors with Chapter 4 “Special Rules for Traders” focuses on qualification for trader tax status. There isn’t one mention in the tax code or these IRS publications that formation of an entity alone trumps Section 212 treatment and would therefore deliver Section 162 trade or business treatment. Ask these salesmen for a tax opinion or statement to back up their schemes. 

Almost all tax court cases relating to traders are about traders who fail to qualify for trader tax status and the court rules they therefore can’t use business expense treatment. Many traders in those tax court cases had formed entities and still failed to qualify for trader tax status. Tax bills are huge since investment expenses are very restricted vs. business expenses. (Read about the Holsinger case inGreen’s 2010 Trader Tax Guide.) 

The best entities for traders
If a trader qualifies for trader tax status and can benefit from an entity, he only needs one simple low-cost entity like a husband/wife general partnership, which has no state filing fees and or state minimum taxes. The biggest state marketplaces for traders are California, Texas, Illinois and New York, and they are all expensive for LLCs vs. general partnerships. 

Promoters harp on two very expensive dual-entities schemes: The more expensive LLC filing a partnership tax return, and the C-corp scheme (facing double taxable and disallowed losses). 

The cash flow savings pitch 
Some salesmen promise tax efficiency to save cash flow for a trading business. This is another pitch that doesn’t add up and in fact is the reverse of what they promise. Most new traders don’t have sufficient funds to invest in their trading activity and they face great challenges in qualifying for trader tax status. Why do these salesmen want to take thousands of dollars from the aspiring trader who doesn’t qualify for trader tax status for entities they don’t need, which then renders them more seriously under-capitalized? Wouldn’t traders be far better served retaining those thousands of dollars to finance their minimum account sizes? After all, a trader needs $25,000 to be a pattern day trader and close to $20,000 to qualify for trader tax status in futures and forex. The IRS doesn’t respect mini and micro accounts for assessing trader tax status. 

The clean up 
Our CPAs are often asked by frustrated clients to clean up messes caused by these promoters. We usually close down excess entities, try to salvage one, or start over. Amended tax returns may be necessary as well. 

More details
We cover trader tax status and entities in detail in Green’s 2010 Trader Tax Guide. Here are some excerpts from Chapter 4 on Entities, specifically on the problems with C-corps:

Although entities aren’t absolutely necessary for business traders to deduct business expenses and elect Section 475 MTM, they’re very helpful in reducing IRS challenges of trader tax status (which are on the rise). Plus, entities are useful in unlocking adjusted gross income (AGI) tax deductions including retirement plans and health-insurance premiums. Entities help most business traders, especially part-time and money-losing traders deflect IRS questions scrutinizing trader tax status. Because the entity return is filed separately, the IRS won’t also see your W-2 (wages) from another full-time job or easily question the validity of a money-losing sole-proprietorship business. 

Business traders often use entities to contribute to a retirement plan, which otherwise isn’t possible unless a trader has other sources of earned income or is a member of a futures exchange. Some traders are interested in launching an investment-management business in the future, and trading in an entity can help constitute a performance record. Finally, many types of entities are useful for asset protection and/or business continuity. A separate legal entity gives the presumption of business purpose, but a trader still must achieve trader tax status. 

ENTITIES ENGINEER EARNED INCOME 
If a trader doesn’t have earned income, he may want to consider the following tax strategy, which isn’t 100-percent clear in the tax law. Form a separate legal entity if you want to contribute to a tax-deductible retirement plan (or even a tax-free retirement plan such as a Roth IRA). The entity is used to engineer earned income — to turn a portion of non-earned income trading gains into earned income. 

Caution: IRS regulations do not allow investment partnerships to issue guaranteed payments (which are earned income) to owners. This could cause the IRS to challenge this strategy. However, various court cases (including Armstrong vs. Phinney) state that the IRS regulation is incorrect. 

PASS-THROUGH ENTITIES ARE BEST
A separate pass-through entity passes all items of income, loss, and expense directly to the trader’s individual tax return, so there’s no double-federal-taxation, as taxes are paid on the owner-level only. States have very low levels of minimum taxes, franchise taxes, or annual reports for LLCs or S-corps. 
• All tax character is detailed on the entity level and then passed through in summary form (maintaining its character) to the owner’s individual tax return. 
• Dividend and interest income is reported on individual Form 1040 Schedule B. 
• Capital gains and losses are reported on individual Form 1040 Schedule D and Section 475 MTM gains and losses are reported on individual Form 1040 Form 4797. The line-by-line reporting is reported on the entity tax return, with summary reporting on the individual return. 
• Business expenses are reported in summary manner on individual Form 1040 Schedule E, with expense details reported on the entity return. 
• Summary reporting on the individual return without using a Schedule C means fewer questions from the IRS. 
Some traders with investor tax status may want to consider an entity, even though they can’t efficiently use the AGI deduction strategies. If they benefit from investment-expense treatment (i.e., they don’t trigger the alternative minimum tax and they’re well over the 2-percent AGI limitation), it looks better to consolidate all those expenses on an entity return and pass them through in summary form to the individual return. It resembles a hedge-fund investment and looks quite normal to the IRS. Otherwise, the IRS might nit pick at investment-expense details on Schedule A. 

C CORPORATIONS ARE THE WORST 
• Paying out salaries or administration fees to avoid double taxation (triggered with C-corps) causes payroll or SE tax that otherwise might not be due, since retirement-plan deduction strategies usually only require a small portion of trading gains to be converted into earned income. 
• The $3,000 capital loss isn’t allowed in a C-corp. Losses are trapped in C-corps until the entity is closed, so traders can’t immediately benefit from losses. You can’t sell tax losses in an entity to another party. 
• Lower 60/40 futures tax rates aren’t allowed in C-corps. 
• Dual entity schemes using a C-corp are often expensive and can have many tax pitfalls. Why use two entities at twice the cost? 
• In some cases, C-corps can be attractive as a second entity, providing the administrative service to a pass-through trading company for fringe benefit plans such as a medical-reimbursement plan. Health-insurance premiums are deductible with pass-through entity structures (on the individual return). 
• If C-corp tax rates become materially less than the highest individual marginal tax rates (which are scheduled to rise in 2011 on the upper income), there may be opportunities for tax savings. 
• Dual-entity schemes marketed by other firms aren’t a good idea. Some accountants recommend C-corps to cover up weak trader-tax status cases. C-corps don’t have the same concept of business vs. investment expenses. But this strategy still fails when a second trading entity such as an LLC pays fees to the C-corp to zero out income after using the C-corp to pay expenses. The LLC partnership return has a restricted investment expense deduction in this case. 

Some suggest another ill-advised angle: Paying a small amount of fees while letting the C-corp build up a higher amount of expenses (which become losses), trying to achieve business ordinary-loss write offs in closing the C-corp in a later year based on Section 1244 ordinary-loss tax treatment. Note that a trading C-corp alone doesn’t qualify for Section 1244 stock-loss treatment, as it fails the necessary business revenues qualification for Section 1244. A dual entity scheme paying fees only to the C-corp (by the trading LLC) might qualify for Section 1244 stock treatment. However, we expect the IRS to treat this scenario as a sham transaction, because the C-corp never achieved business purpose — with the plan of having more expenses than revenues (net losses). 

Alternatively, the IRS may argue the fees paid to the C-corp were below market rate and need to be restated upwards — after all, in an arm’s length transaction, an independent company would charge a customer more than the cost of its expenses. Consult a trader tax expert. It’s better to address whether or not you qualify for trader tax status and plan accordingly around that determination in a more honest approach. Paying thousands of dollars for dual entity schemes up front and having costly tax problems later on isn’t worth it. 


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