Traders qualifying for trader tax status need an S-Corp structure if they want tax-advantaged employee benefit plans, including health insurance and retirement, saving thousands in taxes. Conversely, if they use a partnership or sole proprietor structure, traders cannot have employee benefit plan deductions.
An S-Corp is tax-free on the entity level for federal tax purposes, and most states have small minimum taxes on S-Corps. However, a few jurisdictions have higher taxes: On S-Corp net income, Illinois has a 1.5% Replacement Tax, California a 1.5% Franchise Tax, and New York City an 8.85% General Corporate Tax. In those jurisdictions, I recommend a dual entity structure for high-income traders: A trading general partnership, which is free of state or NYC taxes, and an S-Corp management company with a low income and little state or NYC taxes.
Illinois Replacement Tax
S-Corps and partnerships operating in Illinois are liable for IL replacement tax of 1.5% on net income. There’s an important exception applicable to traders: an “investment partnership” is exempt from IL replacement tax. An investment partnership doesn’t have to file an IL Form 1065 partnership tax return. (See Illinois Income Tax Act Section 1501(a)(11.5)).
The investment partnership exception does not apply to an S-Corp. If the trading company files an S-Corp Form 1120-S federal tax return, it must also file an IL Form 1120-ST (Small Business Corporation Replacement Tax Return) and pay the replacement tax.
California Franchise Tax
S-Corps operating in California are liable for CA franchise tax of 1.5% on net income. The minimum franchise tax is $800 per year, even in a short year. $800 divided by 1.5% equals $53,333. That means an S-Corp owes franchise tax above the $800 minimum tax after net income exceeds $53,333. Deduct officer compensation and employee benefit plans in calculating net income. General partnerships are not liable for an $800 minimum tax, but LLCs are. Only the S-Corp owes 1.5% franchise tax.
New York City General Corporation Tax
You can have an S-Corp for federal and New York State tax purposes, but New York City will disregard your S-Corp tax status and treat it as a C-Corp, a regular corporation. That means New York City will expect your S-Corp to pay General Corporation Tax (GCT) of 8.85% on net income. Reduce net income with deductions for officer compensation and employee benefit plans. If your income is high, you may trigger some “alternative tax,” which requires adding back officer compensation with an alternative tax calculation.
Strategies to limit state taxation
If you have trading gains not exceeding $200,000 per year in Illinois, California, or New York City, it’s okay to use an S-Corp, providing you plan to maximize retirement plan contributions using a Solo 401(k). From the $200,000 trading gains in the S-Corp, deduct the maximum $140,000 of officer compensation needed to unlock the maximum Solo 401(k) plan contribution limit of $53,000, or $59,000 with the over-age 50 catch-up provision. Net income will be low, thereby limiting state or NYC taxes.
If you consistently have trading gains over $300,000 per year in Illinois, California, and New York City, consider a dual entity structure: A trading general partnership, which is free of state or NYC taxes, and an S-Corp management company with a low income and little state or NYC taxes.
The trading company pays the management company monthly administration fees, and a “profit allocation,” which is a share of trading gains. With this income, the management company pays officer compensation and employee benefit plans. The goal is for the management company to have a minor net income to reduce state or NYC taxes. With proper tax planning, tax savings from the dual-entity solution should well exceed tax compliance costs for the two entities.
State and city taxation varies, so consult with a trader tax advisor.
Darren Neuschwander CPA contributed to this blog post.