Category: Entities

Execute S-Corp Officer Compensation With Employee Deductions Before Year-End

December 10, 2019 | By: Robert A. Green, CPA

TTS traders need an S-Corp trading company to arrange health insurance and retirement plan deductions. These deductions require earned income or self-employment income. Unlike trading gains, S-Corp salary is considered earned income.

The S-Corp must execute officer compensation, in conjunction with employee benefit deductions, through formal payroll tax compliance before the year-end 2019. Otherwise, traders miss the boat. TTS is an absolute must since an S-Corp investment company cannot have tax-deductible wages, health insurance, and retirement plan contributions. This S-Corp is not required to have “reasonable compensation” as other types of businesses are, so a TTS trader may determine officer compensation based on how much to reimburse for health insurance, and how much they want to contribute to a retirement plan. If you are in the QBI phase-out range, you might wish to have higher wages to increase a QBI deduction. For payroll tax compliance services, I recommend paychex.com; it has a dedicated team for our TTS S-Corp clients. Sole proprietor and partnership TTS traders cannot pay salaries to 2% or more owners.

TTS S-Corps may only deduct health insurance for the months the S-Corp was operational and qualified for TTS. Employer-provided health insurance, including Cobra, is not deductible. It doesn’t need to be profitable for the health insurance deduction.

A taxpayer can deduct a contribution to a health savings account (HSA) without TTS or earned income. HSA contribution limits for 2019 are $3,500 individual and $7,100 for family coverage. There’s an additional $1,000 for age 55 or older. Some employers offer a flexible spending account (FSA) for covering health care copayments, deductibles, some drugs, and other health care costs. Both HSAs and FSAs must be fully funded and utilized before the year-end.

TTS S-Corps formed later in the year can unlock a retirement plan deduction by paying sufficient officer compensation in December when results for the year are evident. Traders should only fund a retirement plan from trading income, not losses.

You must open a Solo 401(k) retirement plan for a TTS S-Corp with a financial intermediary before the year-end 2019. Plan to pay the 2019 100%-deductible elective deferral amount up to a maximum of $19,000 (or $25,000 if age 50 or older) with December payroll. That elective deferral is due by the end of January 2020. You can fund the 25% profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $37,000 by the due date of the 2019 S-Corp tax return, including extensions, which means Sept. 15, 2020. The maximum PSP contribution requires wages of $148,000 ($37,000 divided by 25% defined contribution rate). Tax planning calculations will show the projected outcome of income tax savings vs. payroll tax costs for the various options.

Consider a Solo 401(k) Roth, where the contribution is not deductible, but the contribution and growth within the Roth are permanently tax-free. Traditional plans have a tax deduction upfront, and all distributions are subject to ordinary income taxes in retirement. Traditional retirement plans have required minimum distributions (RMD) by age 70½, whereas Roth plans don’t have RMD.

Setting up a TTS S-Corp for 2020
If you missed out on employee benefits in 2019, then consider an LLC with S-Corp election for 2020. You can form a single-member LLC by mid-December 2019, obtain the employee identification number (EIN), and open the LLC brokerage account before year-end to begin trading in it on Jan. 1, 2020. The single-member LLC is a disregarded entity for 2019, which avoids an entity tax return filing for the 2019 partial year. A spouse can be added as a member of the LLC on Jan. 1, 2020, which means the LLC will file a partnership return for 2020. If you want health insurance and retirement plan deductions, then your single-member or spousal-member LLC should submit a 2020 S-Corp election within 75-days of Jan. 1, 2020. The S-Corp should also consider making a Section 475 MTM election on securities only for 2020 within 75 days of Jan. 1, 2020.

Clients of our firm GNM should sign up for S-Corp Tax Compliance (Traders) and work with their assigned CPA before the year-end.

If you want to set up an LLC in December with S-Corp election for 2020, start with a 45-minute paid consultation with Robert A. Green, CPA. You can purchase our entity formation service afterward.


How To Structure A Trading Business For Significant Tax Savings

June 26, 2019 | By: Robert A. Green, CPA | Read it on

If you actively trade securities, futures, forex or crypto, consider setting up a trading business to maximize tax benefits. With a sole proprietorship, a trader eligible for trader tax status (TTS) can deduct business and home-office expenses and make a timely Section 475 election on securities for tax loss insurance and a potential qualified business income (QBI) deduction. By forming an LLC taxed as an S-Corp, a TTS trader can also deduct health insurance premiums and a retirement plan contribution. An investor without TTS cannot get any of these tax benefits.

The new tax law (TCJA) severely limits itemized deductions for investors, while expanding the standard deduction and improving business expensing. TCJA also introduced a 20% deduction on QBI, which includes a TTS trading business with Section 475 income but excludes capital gains and portfolio income. With TCJA, TTS and Section 475 are more valuable than ever before.

Table for choosing a TTS trading business structure

Sole proprietorship
An individual TTS trader deducts business expenses and home office deductions on a Schedule C (Profit or Loss From Business – Sole Proprietorship), which is part of a Form 1040 filing. Schedule C losses are an above-the-line deduction from gross income.

It’s easy to set up a sole proprietorship. First, open an individual brokerage account(s) in the trader’s name and social security number. You don’t need a separate employer identification number (EIN) unless you plan to have employees on the payroll. You can also use a joint individual account but list the trader’s name and social security number first. There is no state filing required for a sole proprietorship as there is for organizing an LLC or incorporating a corporation. You also don’t need a “doing business as” (DBA) name, although you can obtain one if you prefer. There isn’t a federal or state tax election for claiming TTS — it’s determined based on facts and circumstances assessed at year-end.

Don’t confuse TTS with a Section 475 election. Only TTS traders can use Section 475 ordinary gain or loss treatment; however, many TTS traders don’t make a 475 election. TTS is like undergraduate school, and Section 475 is like graduate school: The former is needed to get into the latter, but undergraduates don’t necessarily elect to go on to graduate school. For example, a TTS futures trader might skip a 475 election to retain lower 60/40 capital gains rates on 1256 contracts. You can elect Section 475 on securities only, commodities only, or both.

Here’s an example: An active trader realized in mid-2019 that he qualified for TTS for all of 2018. He can add a Schedule C to his 2018 Form 1040 tax return due on an extension by Oct. 15, 2019. (Traders can use TTS on amended tax returns, too.) A Schedule C provides tax benefits for 2018 and year-to-date in 2019. This trader wants to form an S-Corp later in 2019 to unlock a health insurance deduction for the remainder of 2019 and a high-deductible retirement plan deduction. He realized he qualified for TTS after April 15, so was too late to elect 475 on the individual level for 2019. But a new S-Corp can select Section 475 within 75 days of inception so that the trader will be exempt from wash-sale loss adjustments at year-end 2019.

Section 475 tax benefits
TTS traders are entitled to make a Section 475 election, but investors are excluded from it. I call it “tax loss insurance” because the election exempts securities trades from onerous wash-sale loss adjustments, which can defer tax losses to the subsequent year, and the $3,000 capital loss limitation. Ordinary loss treatment is far better; it can generate tax refunds faster than capital loss carryovers.

A partnership or S-Corp formed during the tax year is considered a “new taxpayer,” which can elect Section 475 internally within 75 days of inception. An individual TTS trader had to choose Section 475 with the IRS by April 15, 2019, so a new partnership or S-Corp comes in handy after the April 15 deadline. An existing taxpayer must also file a Form 3115 (Application for Change in Accounting Method), whereas a new taxpayer adopts 475 from inception, so this filing isn’t necessary.

Prior capital-loss carryovers on the individual level still carry over on Schedule Ds. The new entity can pass through capital gains if the taxpayer skips the Section 475 MTM election to use up those capital loss carryovers. Then, the entity can elect Section 475 MTM in a subsequent tax year. It’s easy to revoke a 475 election in a manner that mirrors making a 475 election.

The qualified business income deduction
TCJA introduced a tax benefit for pass-through businesses, which includes a TTS trader with Section 475 income; whether doing business as a sole proprietor, partnership, or S-Corp. Section 199A provides a 20% QBI deduction on a “specified service trade or business” (SSTB), and TTS trading is an SSTB. However, SSTBs are subject to a taxable income threshold, phase-out range, and income cap. The phase-out range has wage and property limitations, too. Also, the 20% deduction is on whichever is lower: QBI or taxable income minus “net capital gains” defined as net long-term capital gains over net short-term capital losses, and qualified dividends. It’s a complicated deduction, and most traders won’t get a QBI deduction. QBI includes Section 475 ordinary income and trading business expenses and excludes capital gains and losses, dividends, interest income, forex and swap ordinary income, and investment expenses.

For 2019, the taxable income (TI) cap is $421,400/$210,700 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The TI threshold is $321,400/$160,700 (married/other taxpayers).

Pass-through entities
A pass-through entity means the company is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their tax returns. Taxpayers should consider marriage, state residence, and state tax rules, including annual reports, minimum taxes, franchise taxes, excise taxes, and more when setting up an entity. In most states, these taxes are nominal costs. (In Green’s 2019 Trader Tax Guide, I address state taxes for S-Corps in California, Illinois, other states, and New York City.)

Partnerships
A trader can organize a spousal LLC and file as a partnership. Alternatively, the trader can form a marital general partnership without liability protection afforded by an LLC. Partnerships file a Form 1065 partnership tax return. Establishing a separate legal entity does not alone generate tax benefits; it’s critical for the organization to qualify for TTS. Otherwise, the company is considered an investment company with suspended investment fees and expenses. An investment partnership cannot have business expenses, officer compensation, and employee benefits, including health insurance and retirement plans.

A TTS trading partnership may deduct business expenses, which the partnership Schedule K-1 reports in line one (“ordinary business income/loss”). The individual owner deducts business expenses. If the partnership agreement provides for it, the partner can also deduct “unreimbursed partnership expenses” (UPE) including home office expenses, on Schedule E page 2 (Supplemental Income and Loss). The amounts are entered on the “non-passive income” column since a TTS loss is exempt from Section 469 passive activity loss rules under the “trading rule” exception.

A partnership tax return looks better to the IRS vs. a Schedule C with different tax forms for trading gains and losses. The partnership return consolidates Section 475 ordinary income/loss with business expenses in line one of Schedule K-1. Partnership capital gains are easy to see on the partnership Schedule K and K-1. On the contrary, there is a red flag with a Schedule C displaying business expenses. Individual-level trading gains and losses are on other tax forms: Form 8949 for capital gains and losses, Form 6781 for Section 1256 capital gains and losses using 60/40 treatment and Form 4797 Part II ordinary gain or loss for Section 475 trades. It’s hard for the IRS to decipher TTS items from investments on an individual tax return. Sole proprietors should use a well-crafted tax return footnote to explain the correlation of a TTS Schedule C with the other tax forms for trading gains and losses.

A partnership (or S-Corp) helps segregate investment positions from TTS/Section 475 trading positions. If you trade substantially-identical positions that you also invest in, it could invite the IRS to play havoc with the reclassification of TTS vs. investment positions. Using a TTS company prevents the IRS from reclassifying TTS positions out of Section 475 ordinary loss treatment into a capital loss limitation on investment positions. And, it prevents the IRS from reclassifying unrealized long-term capital gains on investment positions into TTS/475 MTM ordinary income on TTS positions. Traders cannot use portfolio margining between an entity and an individual account, so they carefully weigh the use of portfolio margining vs. Section 475.

S-Corps
Taxpayers cannot directly create an S-Corp; instead, it’s a tax election. Organize an LLC or incorporate a corporation, and the entity has the option to file an IRS Form 2553 (Election by a Small Business Corporation) within 75 days of inception. Alternatively, in a subsequent year, the S-Corp election is due by March 15. All the owners must be U.S. residents. Most states accept the federal S-Corp election, although some states including but not limited to New York and New Jersey require a separate state election. There is IRS relief for late S-Corp elections; however, you had to have the intention of making the S-Corp election on a timely basis.

New S-Corps (and partnerships) can elect Section 475 within 75 days of inception.

Unlike a partnership, an S-Corp doesn’t require two or more owners. An unmarried trader can form a single-member LLC to elect S-Corp status. Otherwise, a single-member LLC is a “disregarded entity” (a “tax nothing” in the eyes of the IRS), which takes you back to using sole proprietor status on a Schedule C.

The essential tax benefit of an S-Corp is to arrange tax deductions for health insurance premiums and a high-deductible retirement plan contribution through officer compensation.

Sole proprietors and partnerships cannot achieve these employee-benefit deductions in connection with trading income. A Schedule C cannot pay the owner wages, and partnerships should use “guaranteed payments” instead of salaries. Partnership expenses flow through, including a guaranteed payment, creating negative self-employment income (SEI). That makes a health insurance and retirement plan deduction challenging to achieve for a TTS partnership. Conversely, S-Corps don’t pass through negative SEI, and the employee benefit deductions work tax efficiently.

S-Corp health insurance premiums
TTS traders with significant self-employed health insurance (HI) premiums should consider an S-Corp to arrange a tax deduction through officer compensation; otherwise, they cannot deduct HI.

Not everyone needs a health insurance deduction, but if you do, crunch the numbers. An S-Corp is worthwhile if the HI tax deduction is meaningful, and the tax savings exceed the entity costs of formation and maintenance. A retirement plan deduction adds icing on the cake.

Examples: An unmarried futures trader living in a tax-free state might be in the lowest two tax brackets of 10% and 12%, after taking the standard deduction. With 60/40 treatment on Section 1256 contracts, her blended tax rate is 4% and 4.8%. If her HI deduction is $3,600, then the tax savings is $173. That’s far less than the cost of maintaining an S-Corp. A payroll service provider might cost $600 per year.

On the other hand, a married securities trader in a high-tax state might have a $24,000 HI deduction for family coverage, and with a 40% combined federal and state tax bracket, the tax savings for the HI deduction is $9,600. An S-Corp is a good idea for this trader.

The health insurance deduction is complicated for officer/owners: Add health insurance premiums paid by the entity or individually during the entity period to wages in box one on the officer/owner’s W-2. The health insurance amount in salary is not subject to payroll taxes, so omit this amount from Social Security wages in box 3, and Medicare wages in box five. The officer deducts health insurance premiums as an adjusted gross income (AGI) deduction on his Form 1040 personal tax return. The taxpayer deducts non-owner employees’ health insurance on the S-Corp tax return directly as “insurance expense.”

S-Corp retirement plan contributions
Taxpayers need self-employment income (SEI) to make and deduct retirement plan contributions; however, trading income is not SEI. (The exception is a full-fledged dealer/member of an options or futures exchange, trading Section 1256 contracts on that exchange.) There are tax costs and benefits to SEI: It triggers SE tax but also unlocks a HI and retirement plan deduction. SE tax is the same as payroll tax (FICA and Medicare), which I explain below.

A TTS trader uses an S-Corp to pay officer compensation for these employee benefit deductions. The trader is in control of how much to run through payroll, picking an amount to maximize employee benefit deductions but not to pay too much in the payroll tax.

You should fund retirement plan contributions from net income, not losses. It’s best to wait on the execution of an annual paycheck until early December when there is transparency for the year. A trader should not have a base salary throughout the year. Some traders make money during the year, only to lose it before year-end.

If you have sufficient trading profits by Q4, consider establishing a Solo 401(k) retirement plan before year-end. It’s a defined contribution plan; start with the 100% deductible elective deferral (ED; $19,000 for 2019) and pay it through payroll since it’s reported on the annual W-2. Add the ED to Social Security wages and Medicare wages on the W-2 but not taxable wages in box 1, as that is where the tax benefit (deduction) is. The gross wage ED component is subject to payroll taxes, and the S-Corp tax return has a deduction for gross wages. Taxpayers 50 years and older have a “catch up provision” of $6,000, raising the ED limit to $25,000 per year.

If you have large trading gains, consider increasing payroll in December for a performance-based bonus to unlock a 25% deductible Solo 401(k) profit-sharing plan (PSP) contribution that you don’t have to pay into the retirement plan until the due date of the S-Corp tax return (including extensions by Sept. 15). The maximum PSP amount is $37,000. The total limit for a Solo 401(k) is $62,000 ($19,000 ED, $6,000 catch-up ED, and $37,000 PSP). The S-Corp tax return deducts the PSP.

A “traditional” retirement plan is tax deductible, and the related wages are subject to a payroll tax, which includes 12.4% FICA up to the SSA base of $132,900 for 2019, plus 2.9% Medicare tax without a base limit. If the trader is in a high tax bracket, then the income tax savings can well exceed the payroll tax cost, which is also 50% deductible. Crunch the numbers in December for year-end tax planning and consider whether you can afford to save this cash flow until retirement, starting at age 59½ for required minimum distributions.

As an example: Assume an unmarried trader, age 51, has S-Corp net trading income of approximately $225,000 and individual taxable income of $200,000. That puts her in a 32% marginal federal tax bracket, and she lives in a tax-free state. On officer compensation of $25,000, she contributes the maximum Solo 401(k) ED of $25,000, saving $8,000 in federal income taxes. Her payroll tax on $25,000 wages is $3,825, which is 50% tax deductible, so it generates additional income tax savings of $612. She has federal unemployment insurance (FUI) of $50 and is exempt from state workmen’s compensation insurance. Her net overall tax savings is $4,737. She will enjoy tax-free compounding of growth in the retirement plan until she must begin taking required minimum distributions by age 70½, which is taxable income at ordinary rates.

Consider a Roth Solo 401(k) contribution in the years when you can skip an income tax deduction. Roth plans are permanently tax-free for growth and contributions. Early withdrawals can trigger a 10% excise tax penalty. If you have another job with annual wages over the SSA base, then TTS S-Corp wages will convert new FICA to a federal tax credit, since the IRS does not double-charge FICA on a Form 1040. This credit gives a nice incentive to consider a Roth plan.

S-Corp payroll
To arrange employee benefits including health insurance and retirement plan deductions through an S-Corp, you’ll need to pay officer compensation through a formal payroll before year-end. You’ll likely need to engage a payroll service provider for payroll tax compliance. (Our firm works with a dedicated team at Paychex for a price of approximately $600 per year.) If you don’t need employee benefits in a given tax year, you can skip paying officer compensation for that year. IRS “reasonable compensation” rules for S-Corps probably don’t apply to traders since the S-Corp has unearned income. However, the IRS could take the position that reasonable compensation is required in all cases. Once you begin a payroll, you must continue to file payroll tax returns quarterly and annually, even if they are zero returns due to no salary in any given period.

A payroll service includes quarterly payroll tax returns (Form 941), the annual payroll tax return (Form 940), state payroll tax returns and federal unemployment insurance with FUI tax of under $50 for the owner/trader. In most states, the trader/owner is exempt from state unemployment insurance and state workmen’s compensation. The payroll service provider also prepares the W-3s and W-2s

One benefit is you can withhold taxes from payroll in December and have them attributed to being made throughout the year. Take advantage of this tax loophole to reduce quarterly estimated tax payments during the year. Benefit from hindsight and use of the cash flow.

Avoid wash sales with an entity
Permanent wash-sale losses between individual taxable accounts and IRAs and deferred wash-sale losses inside and between taxable accounts significantly impact active investors.

Trading in an entity account might help avoid these problems. The entity is separate from the individual and IRA accounts for purposes of wash sales since it is a different taxpayer. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s accounts. If the company qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions).

Trade accounting for securities is more comfortable with a new entity since there are no opening-year wash-sale loss adjustments to reverse from the prior year-end, which is sometimes difficult to determine.

Miscellaneous
S-Corps are more formal than partnerships. For example, a TTS trader needs to use an accountable reimbursement plan before year-end for reimbursing the officer’s business expenses. A partnership is less formal; it can use unreimbursed partnership expenses (UPE).

Form the pass-through entity in your state of residence since it passes income to that state, anyway. Don’t be fooled by asset-protection salesman promoting entity formation in tax-free jurisdictions. You live, work, and trade in your home state.

C-Corps are not ideal for traders since the IRS might charge a 20% accumulated earnings tax on top of the 21% flat tax. It’s hard for a trader to have a war chest plan to justify retaining earnings and profits (E&P). There’s double state taxation to consider, too. (See Green’s 2019 Trader Tax Guide.)

Some brokers charge higher professional rates for data feed fees on entity accounts, even though you don’t have investors. A sole proprietor individual account pays non-professional rates, which can save $125 or more per month depending on how many data vendors you have. Inquire about this issue with your brokers.

Qualifying for trader tax status
Many traders and tax advisers don’t fully comprehend TTS, including how to use it properly. Rather than deal with its many nuances, they skip TTS and overlook or miss the 475-election deadline. It’s sad to explain to new clients why they cannot deduct trading expenses and losses.

TTS is the linchpin for the related tax advantages of using an entity. Before forming a company, determine if you qualify for it. An entity does not deliver business expense treatment or automatically provide an opportunity for employee benefits. The organization must be eligible for TTS; otherwise, it’s an investment company like the majority of hedge funds.

To be eligible for claiming TTS, a trader needs approximately four total trades or more per day, trade executions on close to four days per week, with more than 15 total trades per week, 60 trades per month, and 720 trades per year (annualized), per the Poppe court. Average holding periods must be under 31 days per the Endicott court. There are several other factors including having material account size ($25,000 for pattern day trader designation on securities and $15,000 for other instruments), spending over four hours per day, having the intention to run a business to make a living, having trading computers and multiple monitors, and a dedicated home office.

If you have segregated investment positions, it’s better to house your TTS trading in a separate entity. Otherwise, the IRS might drag investment positions into the TTS analysis, which can lengthen holding periods over the 31-day requirement.

Investment vs. TTS business expenses
TCJA suspended all investment fees and costs except for two: investment-interest expense limited to investment income, and stock borrow fees, which are considered “other itemized deductions.” Many traders will use the roughly doubled standard deduction instead of itemized deductions, especially considering the SALT itemized deduction cap of $10,000. The 2019 standard deduction is $12,200 single and $24,400 married.

Trading commissions are not separate expenses; the broker deducts them from sales proceeds and adds them to cost-basis for purchases. Commissions are therefore part of trading gain or loss. With net capital gains, commissions are equivalent to a tax deduction; however, with a capital loss limitation, commissions are part of a capital loss carryover. This can’t be changed even with TTS.

TTS business expenses include expensing of computers, monitors, and mobile devices, home-office expenses if exclusively used for business, post-TTS commencement education costs, Section 195 startup costs including pre-business education going six months back, and Section 248 organization expenses. Additional expenses include data and market information services, subscriptions, charting and other software, platform fees, self-created algorithms and automated trading systems, margin interest, stock borrow fees, coaches, mentors, chatrooms, supplies, seminars, travel, meals, professional expenses including tax advice, and more.

A typical TTS trader has annual business expenses ranging between $5,000 and $25,000 per year. Expect higher costs if there are significant stock borrow fees, margin interest expenses, an outside office, staff, or using a Bloomberg terminal. Forex traders tend to have few costs.

With a TTS S-Corp, the health insurance deduction could range from a few thousand to $24,000 or more per year depending on if the trader is single, married, and has children with family coverage. It could be low with an Obamacare subsidy. A Solo 401(k) retirement plan deduction could be up to $62,000 per year per working spouse.

If you want an entity for 2019, you should set it up by the end of Q3. Come November, the window of opportunity closes as two months is too short a period for TTS and to build up employee benefits. In that case, form it in December to be ready for use Jan. 1, 2020.

Consider a 45-minute consultation to review eligibility for TTS, an entity formation plan, Section 475 election, and more. If an entity is a good idea for you, then consider our entity formation service. We also offer our tax compliance service, starting with year-end planning in December.

GNM CPAs Darren Neuschwander, and Adam Manning contributed to this blog post.

For more in-depth information on entities for traders, health insurance, retirement plans, trader tax status, Section 475, QBI and other issues discussed in this blog post, see Green’s 2019 Trader Tax Guide.

Attend our upcoming Webinars on this subject and watch the recording after.


How To Avoid IRS Challenge On Your Family Office

June 28, 2018 | By: Robert A. Green, CPA | Read it on

Investors may no longer deduct investment expenses, including those passed through from an investment partnership. Restructuring these expenses into a management company might achieve business expense treatment providing it’s a genuine family office with substantial staff rendering financial services to extended family members and outside clients.

The IRS might assert the family office is managing “one’s own investments,” not for outside clients, so the management company is also an investment company with non-deductible investment expenses. Before you go in that direction, it’s wise to learn the lessons of the Lender Management court case from December 2017, which is one of the first on family offices.

Size matters
A single-family office serves one ultra-wealthy extended family, whereas, a multi-family office handles more than one family. Well-established single- and multi-family offices offer a wide variety of financial services, including wealth management, financial planning, accounting, tax, and personal finance. They have substantial staff and salaries, offices, equipment, and operations — the markings of an independent financial services company.

Family office requirements
A family office management company with underlying investment partnerships can use business expense treatment when it has the following characteristics, borne out of the Lender Management tax court case and earlier case law:

– It’s a functional financial services company with significant staff and salaries, an office, equipment and bona fide operations.
– It operates in a continuous and business-like manner.
– Its staff has expertise that is valuable to its clients.
– A profit-allocation of capital gains is considered advisory fee compensation for services rendered. It gets paid more than just its share of profits based on capital.
– It should be profitable.
– It caters to many extended family members with diverging financial needs. It does not operate with a single mindset but provides customized services to each family member.
– Family members and their investment partnerships are not obligated to use the family office.
– There should not be a majority of common ownership between the management company and investment partnerships (this factor is critical).
– It’s safer to have third-party clients who are not family members (a suggestion, not a requirement).

Small family offices have trouble
If two spouses own an investment partnership and management company, then the family office has 100% common ownership, which fails the requirements. The micro family office renders services exclusively to the spousal-owned investment partnership. The management company does not function as an independent financial services company, with outside staff or an outside office. It does not stand alone as a financial service provider. In the eyes of the IRS, it oversees its own investments. This management company should not use business expense treatment. (Some trader accounting and law firms sold this scheme to traders who do not qualify for trader tax status. I’ve always said it did not work and the Lender court confirms it doesn’t work.)

Management fees and carried interest
Consider this typical example: An investment partnership pays a 0.5% management fee on funds under management of $1M ($5,000 per year). The investment partnership also pays a 20% profit allocation (carried interest) based on performance (say, $50,000 for the year). The investment partnership passes through an investment expense of $5,000 for the management fee, which the investor cannot deduct on their tax return. The profit allocation avoids the investment expense deduction problem because it carves out a share of capital gains on each investor’s Schedule K-1.

The management company reports $5,000 of revenue for the management fee, which gives the impression of being a trade or business. However, that’s not enough revenue to cover expenses, so it lacks presumption of business purpose. The management company also reports capital gains income of $50,000 from the profit allocation of investment income. Total income is $55,000 minus business expenses of $52,000 equals a net income of $3,000. The capital gains help satisfy the presumption of business purpose test. The owner sacrificed the $5,000 deduction in the investment partnership to arrange $52,000 of deductions in the management company. However, the IRS might disallow the entire $52,000 deduction, asserting the management company is also an investment company with non-deductible investment expenses because it did not satisfy the requirements for a family office under the Lender court.

Hedge funds
Assume a hedge fund manager owns the management company, which deducts business expenses. The hedge fund partnership does not qualify for trader tax status, so it’s an investment partnership. Most hedge funds meet this scenario. The management company is genuine, and there is little common ownership because the hedge fund is predominately owned by outside investors. That satisfies the Lender court requirements for a management company.

It might be different for a startup hedge fund before outside investors become limited partners in the limited partnership. Until and unless that happens, the manager is managing his own investments, and it fails Lender. The limited partnership is probably not paying the management company advisory fees including profit allocation in connection with the managers capital.

Lender Management tax court case
In Lender Management v. Comm. (Dec. 16, 2017), the tax court overruled the IRS by awarding business expense treatment to Lender Management. It was a well-established single-family office servicing many family-owned investment partnerships. Lender provided customized investment and management services throughout the year to many different family members, with varying needs, across an extensive family tree. Lender Management and the investment partnerships did not have too much common ownership according to IRS and tax court calculations. Only a few of Lender’s dozens of family members owned the management company.

The IRS was unable to cite attribution rules that should apply to Lender. The Lender case also dealt with how to handle revocable vs. irrevocable trusts in the overlap test for common ownership. The Lender court did not define how much overlap ownership is permitted.

Other tax court cases
In Higgins v. Comm. (1941), the tax court said, “No matter how large the estate or how continuous or extended the work may be, overseeing the management of one’s own investments is generally regarded the work of an investor.”

In Dagres v. Comm. (2011), “Selling one’s investment expertise to others is as much an expertise as selling legal expertise, or medical expertise.”

Trade or business partnerships
In Higgins, replace the words “business” for “investment” and the outcome is favorable: “Overseeing the management of one’s own businesses is generally regarded as the work of a business.” If there is a trading partnership with trader tax status, or a rental real estate partnership with ordinary income, then the management company can look through to the business treatment.

A C-Corp management company
Some families and tax advisors are considering a C-Corp management company to take advantage of the new tax law’s 21% flat rate.

Be sure the management company meets the Lender court requirements for a family office. Otherwise, the IRS does not permit a C-Corp investment company to deduct investment expenses. Section 212 (investment expenses) applies to non-corporate taxpayers, not corporations. A C-Corp with a trade or business is entitled to deduct business expenses in connection with making ancillary investments, like investing treasury capital.

When taking into account the Tax Cuts and Jobs Act, don’t focus solely on the federal 21% flat tax rate on the C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified dividends, corporate taxes in 44 states, and IRS 20% accumulated earnings tax assessed on excess retained earnings, which is any amount above zero for an investment company. (See How To Decide If A C-Corp Is Right For Your Trading Business.)

Apportionment between investment and business partnerships
Family offices might want to consider having more of their underlying investment partnerships achieve business treatment, like trader tax status or rental real estate income. If a family office does not satisfy the requirements, and it services investment partnerships and business partnerships, it might consider using hybrid reporting to apportion business expenses vs. investment expenses.

Wealthy families diversify their interests and invest in family-owned investment partnerships in securities and commodities, outside hedge funds, private equity funds, venture capital funds, and real estate partnerships and REITs. Consult a tax advisor to learn more about which underlying investment partnerships have investment expense treatment vs. trade or business activities.

Darren Neuschwander, CPA, and Roger Lorence, Esq., contributed to this post.


A Few States Tax S-Corps: Traders Can Reduce It

July 6, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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.

Read my upcoming five-part blog series and attend our Webinar: Tax Battle Of The States.

Darren Neuschwander CPA contributed to this blog post.


Safeguard Use Of Section 475 By Trading In An Entity

May 10, 2016 | By: Robert A. Green, CPA

Section 475 “tax loss insurance” is a fantastic tax benefit for active securities traders qualifying for trader tax status (TTS). Many individual taxpayers have been using it successfully for years. I’ve exhorted the benefits since 1997, when Congress enacted Section 475 tax law for traders.

Some Section 475 provisions are vague
Increasingly, my firm’s tax compliance CPAs have noticed problems with the nuances of Section 475, including some of the rule sections, which are too vague. The IRS acknowledged this with its “Section 475 Clean Up Project” and read our comment letter to the IRS. The IRS said the project is being completed and to expect updated Section 475 regulations in the summer of 2016. (I cover the changes being discussed at tax attorney conferences in my next blog post IRS Considering “Freeze and Mark” for Section 475 Election.)

One of the problems with Section 475 regulations has to do with segregation of investments. Segregation should be done in form and substance and that can be confusing. A prior IRS proposed regulation called for designation of investment accounts, but that was not sufficient as traders could use substance to trump form.

This problem arises when a trader uses Section 475 and also holds investment positions in substantially identical positions. Traders can’t elect Section 475 by account. The law makes the election by taxpayer identification number, which means the election applies to all active trading accounts and investment accounts containing active trading.

Traders can solve this problem by housing the trading business using Section 475 in a separate legal entity and holding investments in individual accounts. This is the only way to fully segregate investments from trading. (Read my recent blog post Active Traders Should Consider An Entity For Tax Savings for other reasons to form an entity.)

Misidentified investment positions
Many individuals trade substantially identical positions between Section 475 active trading accounts and taxable investment accounts, including joint and spousal accounts. For example, they trade Apple options in a Section 475 account and also hold Apple equity in segregated investment accounts.

The IRS can view this trading as gaming the system, with the trader deducting ordinary losses on Apple options but deferring taxes on unrealized long-term capital gains in Apple equity held as an investment. Because Apple options and Apple equity are substantially identical positions, the IRS has the power in Section 475 regulations to treat either the Apple options or the Apple equity as “misidentified investment positions,” which means it can apply Section 475(d)(2). (Learn more about that Section 475 penalty in my blog post IRS Plays Havoc with Traders Misidentifying Investments.)

Experienced trader tax preparers and IRS agents may seek other ways to address this problem, including reclassifying Section 475 ordinary losses on Apple options as investment capital losses, which then triggers capital loss limitations and wash sale loss adjustments on substantially identical positions across all accounts. Or if it’s better for the IRS position, reclassifying Apple equity investments as Section 475 trades, triggering Section 475 MTM ordinary income treatment, thereby losing tax deferral and missing out on lower long-term capital gains rates on realization.

An entity solves the problem
Traders can avoid this problem by ring-fencing Section 475 trades in separate entity accounts and holding investments in individual accounts. A separate legal entity has a different taxpayer identification number vs. an individual taxpayer social security number.

Don’t transfer investment positions into the entity, as that brings the same problem to the entity-level: having trading and investment accounts and or positions on the same taxpayer identification number.

I suggest that traders using portfolio margining on investment positions make the following decision. Either bring investments into the trading entity for portfolio margining and don’t elect Section 475 in the entity or leave the investments out of the entity and elect Section 475.

A newly formed entity may elect Section 475 by placing a resolution in its own books and records within 75 days of inception. Existing taxpayers must elect Section 475 by making an election statement with the IRS by the due date of the prior year tax return, and later file a timely Form 3115 for the year of the election. (Read my blog post Traders: Consider Ordinary Loss Election By Tax Deadline for more details on making the election.)

IRS scrutinizes individuals with large Section 475-related NOL tax refunds
It’s been over a decade since Chen vs. Commission (2004), but an IRS official recently reiterated the importance of that landmark tax court case, deeming similar cases “Chen cases.”

The IRS official was referring to sole proprietor (individual) traders reporting large Schedule C and Form 4797 (Section 475) ordinary losses on individual tax returns and filing for large NOL carryback refunds claims with the IRS. All the cases in my Green’s 2016 Trader Tax Guide, including Assaderaghi, Nelson, Endicott and Holsinger are similar: individuals with Schedule C and Form 4797 losses.

It’s much better to file as an entity trader with Section 475 ordinary loss treatment. The tax refund is the same, but you substantially reduce your chances of IRS exam and denial of TTS, which is required for use of Section 475.

Section 475 tax benefits
Securities traders qualifying for TTS benefit from a Section 475 election. Section 475 securities trades are exempt from wash sale loss adjustments and a capital loss limitation. Section 475 has business ordinary loss treatment, which offsets income of any kind and contributes to net operating losses (NOLs), which may be carried back two years and/or forward 20 years. Short-term capital gains and Section 475 MTM gains are taxed at the ordinary tax rate, so Section 475 is recommended for securities traders.

Conversely, Section 1256 contract traders (futures and more) generally don’t want Section 475 since they would lose lower 60/40 capital gains tax rates in Section 1256 (60% is a long-term capital gain taxed at lower rates and 40% is a short-term capital gain).

Traders can elect Section 475 on securities only, retaining Section 1256 treatment on futures. Section 475 does not apply to segregated investments. Traders value ordinary loss treatment: It’s free tax loss insurance for securities traders.

I’ve been advising traders on tax matters for over 30 years and I’ve seen many ups and downs in the financial markets. I’ve seen professional traders with wide fluctuations of income and loss, too. It’s important to avoid the dreaded $3,000 capital loss limitation against other income and benefit from Section 475 ordinary business loss treatment to generate immediate tax refund relief.

 

 


Active Traders Should Consider An Entity For Tax Savings

May 3, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Forming an entity can save active investors and business traders significant taxes. Active investors can limit wash sale losses calculated between their individual taxable investment accounts and IRAs with an entity account. 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. For many active traders, an entity solution generates tax savings in excess of entity formation and compliance costs.

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.

Additionally, 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 whom must file a Form 3115 after filing an external election with the IRS.

Don’t worry, prior capital loss carryovers on the individual level are not lost; they still carry over on your individual Schedule D. The new entity can pass through capital gains if you skip the Section 475 MTM election to use up those capital loss carryovers. After using up capital loss carryovers, your entity can elect Section 475 MTM in a subsequent tax year.

Business traders often use an S-Corp trading company or an S-Corp or C-Corp management company to pay salary to the owner in connection with a retirement plan contribution, which otherwise isn’t possible in a partnership trading company (unless a trader has other sources of earned income or is a dealer member of a futures or options exchange).

Trading in an entity can help constitute a performance record for traders looking to launch an investment-management business. Finally, many types of entities are useful for asset protection and business continuity. A separate legal entity gives the presumption of business purpose, but a trader entity still must achieve TTS.

Avoid wash sales with an entity
Active investors in securities are significantly impacted by permanent and deferred wash sale losses between IRA and individual taxable accounts.

Trading in an entity helps avoid these problems. The entity is separate from your individual and IRA accounts for purposes of wash sales since the entity is a different taxpayer. An individual calculates wash sales among all their accounts. Ring fencing active trading into an entity account separates those trades from the individual wash sale loss calculations. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s individual accounts. In that case, the entity will not avoid wash sale loss treatment.

If you don’t purposely avoid wash sales, you can break the chain on year-to-date wash sales in taxable individual accounts by switching over to an entity account mid-year or at year-end, and prevent further permanent wash-sale losses with IRAs. If the entity qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions); that also negates related party rules.

Play it safe on related party transaction rules by avoiding the repurchase of substantially identical positions in the new entity after taking a loss in the individual accounts.

Business traders: consider an entity
Many active traders ramp up into qualification for TTS. They wind up filing an individual Schedule C (Profit or Loss from Business) as a sole proprietor business trader the first year. That’s fine. They deduct trading business expenses on Schedule C and report trading gains and losses on other tax forms. They can even elect Section 475 MTM by April 15 of a given tax year to use ordinary gain or loss treatment (recommended on securities only). But a Schedule C owner may not pay himself compensation and the Schedule C does not generate self-employment income, either of which is required to deduct health insurance premiums and retirement plan contributions from gross income. (The exception is a full-fledged dealer/member of an options or futures exchange trading Section 1256 contracts on that exchange; they have SEI per Section 1402i.) The business trader needs an entity for those employee-benefit plan deductions.

Safeguard use of Section 475

Pass-through entities
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 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.

The best types of entities
We like the S-Corp because it pays compensation (officer’s salary) to the owner, which efficiently unlocks health insurance premium and retirement plan contribution deductions. You can form a single-member LLC or multi-member (spousal) LLC and the LLC can elect S-Corp tax treatment within 75 days of inception or by March 15 of the following tax year. (Another option is to form a corporation and it can elect S-Corp tax treatment, too.) A general partnership can also elect S-Corp status in every state except Connecticut, the District of Columbia, Michigan, New Hampshire, New Jersey and Tennessee.

But the S-Corp is not feasible alone in some states or cities, including California and New York City. In those places, we suggest a trading company partnership return — either a general partnership or LLC — and a management company S-Corp or C-Corp. You can convey interests in the pass-through entity to family revocable trusts or even irrevocable trusts. (See our blog post Business Traders Maximize Tax benefits with an S-Corp.)

Year-end Entity planning
There are important tax matters to execute with entities before year-end. For example, S-corps and C-corps should execute payroll before year-end. A Solo 401(k) defined contribution plan or defined benefit retirement plan must be established before year-end. (Watch our Webinar recording: Year-End Planning For Entities: Payroll, Retirement and Health Insurance.)

This is an excerpt from Green’s 2016 Trader Tax Guide.

Webinar 5/17:  Entity & Benefit Plan Tax-Advantaged Solutions 2016. We plan to offer a recording afterwards. 

 

 


S-Corps: Use Accountable Plan Before Year-End

December 16, 2015 | By: Robert A. Green, CPA

One formality of using an S-Corp is that it should have an accountable plan for reimbursing employee expenses, including the employee’s home-office deduction. Without an accountable plan, employees report unreimbursed employee business expenses on Form 2106, which is part of miscellaneous itemized deductions only deductible in excess of 2% of AGI and not deductible for AMT. With proper usage of an accountable plan, the S-Corp reports the deductions on its tax return.

Expense reporting is more relaxed with partnership tax structures. Partners may report unreimbursed partnership expenses (UPE) on their individual tax return Schedule E, including home office deductions from Form 8829. S-corporation shareholders generally cannot deduct unreimbursed business expenses on Schedule E because the shareholders are categorized as employees when performing services for the corporation.

If you don’t have an accountable plan, draft one as soon as possible and use it before year-end. For home office deductions, reference Form 8829 as a guide for the S-Corp for reimbursement.

Click here for a sample accountable plan.

Learn more about accountable plans on our recommended payroll service provider’s Website at http://www.paychex.com/articles/finance/using-accountable-plans-benefits-both-employers-and-employees.

If you need help with an accountable plan, email us at info@gnmtradertax.com or contact your assigned CPA in our firm.


Business Traders Maximize Tax Benefits With An S-Corp

March 6, 2015 | By: Robert A. Green, CPA

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S-Corp elections are due by March 15, 2015 for existing entities.

Forming an entity taxed as an S-Corp can save active business traders significant taxes. With an S-Corp, business traders solidify trader tax status, maximize employee-benefit deductions (such as health insurance and retirement plan deductions) and gain flexibility with a Section 475 election.

Tax returns are simple
An S-Corp tax return consolidates your trading activity on a pass-through tax return making life easier for you, your accountant and the IRS. Pass-through means there’s no federal tax on the entity level, which avoids double taxation in C-Corps. (Read our recent blog on corporations.) The S-Corp Form 1120-S reports trading gains, losses and expenses, including officer compensation and profit-sharing plan contributions.

Better than a sole proprietorship
The first tax benefit is business expense treatment (Section 162) rather than restricted investment expense treatment (Section 212). If the S-Corp qualifies for trader tax status, it has business expense treatment; otherwise it’s an investment company with investor tax status. The S-Corp tax return looks better than a sole proprietorship trading business Schedule C. The S-Corp shows all activity, whereas a Schedule C only shows business expenses — with trading gains reported on other tax forms — and that looks like a losing business to the IRS. Business expense treatment saves traders more than $5,000 per year in taxes vs. investment expense treatment.

Sole proprietor business traders cannot have employee-benefit deductions in connection with trading gains. Plus, a sole proprietor cannot pay himself a salary or fee to generate self-employment income (SEI) or earned income, which is required for AGI deductions including health insurance and retirement plans. Those employee-benefit plans can save business traders between $3,000 to $17,000 or more per year if properly arranged with an S-Corp structure.

Better than a partnership tax return
Traders need an entity to financially engineer earned income for health and retirement plan deductions. The S-Corp is better than a partnership tax return for this.

Partnership tax returns are inefficient for employee-benefit plan deductions. Partnership tax returns pass through expenses and net losses for income tax and self-employment income tax — the latter being a problem. The partnership pays a guaranteed payment or administration fee to the owner/trader to create SEI. But after the partnership passes through SEI losses, the net result is a low amount of SEI, which constricts a retirement plan contribution.

It works differently with an S-Corp. The S-Corp pays the owner/trader compensation reported on a W-2. The S-Corp passes through expenses and losses for income tax purposes, but not for SEI tax purposes. Employee-benefit plan deductions are entirely based on the amount of W-2 wages and there’s no reduction of earned income from S-Corp expenses and losses. That key difference unlocks the ability to maximize retirement plan contributions.

Tax planning
The owner/officer can have a base salary for covering the health insurance premium deduction, which is allowed even if the S-Corp has trading losses. If the S-Corp has sufficient trading profits by Q4, establish a retirement plan before year-end. Start with the 100% deductible employer 401(k) elective deferral ($17,500 for 2014 and $18,000 for 2015) and pay it before year-end through payroll since it’s reported on the annual W-2.

If you have large trading gains, increase payroll in December for a performance-based bonus to unlock a 25% employer 401(k) profit-sharing retirement plan contribution. You don’t have to contribute into the plan until the due date of the tax return (including extensions). The maximum defined-contribution profit-sharing plan amount is $52,000 plus $5,500 catch-up for 2014, and $53,000 plus $6,000 catch-up for 2015. (For details about retirement plan choices, limits and savings, see Green’s 2015 Trader Tax Guide Chapter 8.)

S-Corp elections
Existing LLCs, C-Corps and general partnerships may elect S-Corp treatment in every state except general partnerships in Connecticut, the District of Columbia, Michigan, New Hampshire, New Jersey and Tennessee. File a S-Corp election on IRS Form 2553 by March 15, 2015. The effective date of the election is January 1, 2015. Most states accept the federal election; if not, file an election in your home state, too. If you miss the S-Corp election deadline, there is IRS and in some cases also state relief for late filings. You’ll need a perjury statement stating you intended to file the election on time. Existing corporations cause taxation on converting accumulated retained earnings.

A new entity may elect S-Corp treatment within 75 days of inception.

Other rules
If you use an S-Corp, read Green’s 2015 Trader Tax Guide Chapter 7 on important issues including officer’s reasonable compensation, stock and debt basis, accounting allocations and more. Underlying income from a trading business is not earned income, so IRS reasonable compensation rules do not apply.

Bottom line
If you’re interested in making an S-Corp election, contact your tax advisor well before the March 15 deadline. There’s still plenty of time to set up a new S-Corp after March 15 to generate employee benefit plan deductions before year-end.

 


C-Corps Have Limited Use For Tax Savings

February 26, 2015 | By: Robert A. Green, CPA

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A C-Corp can help upper-income taxpayers in business save taxes, but it’s not useful to investors.

Increasingly, upper-income folks and their tax professionals are considering a corporate structure in tax planning in order to avoid Obama-era tax hikes. Starting in 2013, Congress raised the top tax bracket for individuals to 39.6% — effectively 41% after factoring in the Pease itemized-deduction limitation. When the 3.8% Net Investment Tax on unearned income is factored in, the combined individual top rate is a hefty 45%. Upper-income taxpayers are rewarded with an 11% or more tax savings when they can shift income from their individual to corporate tax returns. Plus, Congress is discussing corporate tax reform and they may reduce corporate rates widening the gap with individual rates.

Active traders who don’t qualify for trader tax status (business treatment) wonder if a corporate structure allows trading expense deductions considering that Section 212 investment expenses are restricted on individual tax returns. Corporations cannot deduct Section 212 investment expenses; therefore they don’t provide tax relief when a trader does not qualify for trader tax status.

Businesses can efficiently shift income to a corporation
A pass-through-entity trading business – like an LLC or S-Corp – qualifying for trader tax status has business expense treatment. Administration fees paid to a management company organized as a corporation are a business deduction on the pass-through entity. The receiving corporation has business income and expense treatment.

Business treatment on both the pass-through entity and corporation translates to tax efficiency.

Investors cannot efficiently shift income to a corporation
A pass-through-entity investment company has Section 212 investment expense treatment on the individual owner’s level for administration fees paid to a management company organized as a corporation.

That’s not tax efficient since investment expenses face significant limitations on individual tax returns, including the 2% AGI threshold for miscellaneous itemized deductions and the Pease itemized deduction limitation. Miscellaneous itemized deductions are not deductible for AMT tax.

If the investment company allocates a share of trading gains to the management company corporation in lieu of paying fees, the corporation doesn’t have business purpose. Plus, the corporation could be deemed a personal holding company (PHC) subject to a PHC surtax of 20% on undistributed PHC income. A corporation may not deduct non-business expenses including Section 212 investment expenses, which only individuals may deduct.

Corporations deduct business expenses, not investment expenses
Corporations with business activities may deduct Section 162 trade or business expenses. Corporations aren’t permitted to deduct non-business expenses including Section 212 investment expenses for individuals. When a corporation with established trade or business has ancillary investment expenses related to their business activities — like investing working capital — those expenses are deemed Section 162 business expenses and not Section 212 investment expense. Pure investment companies structured as a corporation may not deduct investment expenses. Pass-through entities with investor tax status report investment expenses on Schedule K-1 issued to individual owners.

Tax law is clear
Our CPA firm researched this tax law: It’s clear Section 212 is for individuals only, and corporations need business purpose to deduct Section 162 business expenses. Corporations cannot deduct non-business expenses. I spoke with an IRS official on this matter and his informal advice was to agree with the position stated in this blog.

Here are some excerpts from highly respected tax publication Bittker and Eustice on “Corporate Deductions.”

  • “The Code allows individuals to take a number of deductions that are not allowed to corporations, including the standard deduction, (investment expenses)…. (the code) prevent restrictions aimed primarily at individuals from being sidestepped by a transfer of the restricted activities to a closely held corporation…Section 212 is restricted to individuals, however, presumably on the theory that § 162(a) covers the same ground for corporations that § 162(a) and 212 in combination cover for other taxpayers. Thus, if a corporation engaged in manufacturing holds some securities as an incidental investment, the cost of a safe-deposit box, investment advice, bookkeeping, and so forth incurred with respect to the securities would be deductible under § 162(a) as trade or business expenses, even though an individual proprietor holding such securities would have to resort to § 212 as authority for deducting such expenses.”

Warning to traders not qualifying for trader tax status
Traders not qualifying for trader tax status should not use a corporation since they don’t have business purpose and corporations can’t deduct non-business expenses. While a corporation starts off with presumption of business purpose, that alone doesn’t achieve business purpose. The corporation must qualify for a trade or business. For a trader that means qualification for trader tax status. A corporation is not a remedy for not qualifying for trader tax status.

Corporate tax rates are materially lower than individual rates
The corporate tax rate starts at 15% on the first $50,000 of income, 25% on the next $25,000 and it settles in at 34% thereafter. Personal service companies don’t qualify for the lower rates under 34%. Taxpayers generally try to take advantage of the lower bracket rates so if the corporation pays them qualified dividends years later there’s still meaningful cumulative tax savings.

Unlike pass-through entities including S-corps, LLCs and partnerships, a corporation (C-Corp) pays entity-level taxes. (Note: LLCs can also elect C-Corp tax-filing status.) An individual owner pays taxes on qualified dividends paid by the corporation up to a 20% (long-term capital gains) rate. Plus a 3.8% NIT is applied on unearned income if you’re over the AGI threshold. Paying taxes on the entity and individual levels is commonly referred to as “double taxation.” Corporations avoid double taxation by paying compensation to owner/officers. Most states also tax corporations, so double taxation can defeat the purpose of using a corporation in high tax states. (State taxation for corporations is beyond the scope of this blog post; see more information in Green’s 2015 Trader Tax Guide.)

A corporation needs business purpose
Before you jump into reorganization as a corporation, it’s important to understand the pros, cons and potential pitfalls. My bailiwick is investors, traders and investment managers. In a nutshell, adding a corporation as a second entity makes sense for a business trader or investment manager to reduce Obama-era tax hikes on individuals. But using a C-Corp structure for an investment company does not work. Corporations need a business purpose; therefore, investors won’t find salvation using a corporate structure.

A successful strategy for a trading business
Suppose you have a successful trading company LLC that qualifies for trader tax status and files as either a S-Corp or partnership. Consider adding a corporation as a second entity to provide administration services or to hold intellectual property and charge royalties to the trading company LLC. That has the effect of shifting income from your individual tax return to a corporate tax return. Either the S-Corp trading company or C-Corp management company can unlock employee-benefit plan deductions including health insurance and retirement plans. (Investment companies can’t generate compensation or earned income by arranging employee-benefit plan deductions.)

A failed strategy for an investor
Suppose you have an investment activity that doesn’t qualify for trader tax status (business treatment). (Read How to Qualify.) You also don’t offer investment management services to clients, so you don’t have any business purpose.

A tax salesman approaches you and promises tax deductions using a corporation. These promoters find their prey on the trading education and seminar circuit. The promoter says you can dump your education expenses and other startup expenses into a corporation going 18 months back and generate a net operating loss (NOL) in the corporation to carryover to subsequent tax years. The promoter also suggests a second LLC entity for trading.

If that LLC doesn’t qualify for trader tax status and pays the corporation management or administration fees, it will have investment expense treatment. That defeats the purpose and you’re right back at the beginning of the problem with investment expense limitations on your individual tax return. Seminars and pre-business education are generally not deductible as investment expenses pursuant to Section 274(h)(7).

Conversely, the LLC can wait to achieve trader tax status at a later date and pay the corporation fees then, which will be business deductions for the LLC trading business. The promoters argue the corporation can utilize its NOL to offset the income from the trading business LLC. But, that doesn’t work in my view, as the corporation can’t deduct those expenses in the first place without business purpose from its inception. Dumping expenses that lack deductibility into a corporation for later use does not have legal authority.

At best, the corporation is entitled to capitalize Section 195 startup business expenses for a reasonable amount over a reasonable period if it has business purpose in the works. It’s simple for an IRS agent to determine whether a corporation has trader tax status or business revenue and, therefore, to determine whether any expenses are legitimate Section 162 corporate deductions.

Personal holding company taxes
Corporate structures are intended for trade or business, not investment companies. Personal holding company (PHC) law charges additional taxes on corporations straying into non-business activities. There are exceptions from PHC rules for financial institutions including banks and insurance companies, but that list doesn’t include trading companies.

The PHC tax is 20% of undistributed personal holding company income. PHC income (Section 543) includes dividends, interest, royalties (with exceptions), annuities, rents, personal service contracts (with exceptions) and more. Exceptions from PHC income include active business computer software royalties, active business copyright royalties in many fact patterns and personal service contracts when a specific person (talent) isn’t named in the contract (consult a tax expert). PHC income also does not include capital gains on trading, which is the main source of income in a trading company. PHCs are corporations with five or fewer owners and more than 60% of their income is from PHC income. The definition of PHC Section 542 discusses business deductions and it clearly leaves out Section 212 investment expenses (which are for individuals not corporations).

Bottom line
The tax code is written to prevent individuals from skirting the narrow Section 212 investment expense deduction rules. Schemes to dump these expenses into corporations are poorly conceived and will lead to tax trouble.

Business traders and investment managers paying top Obama-era tax rates should consider adding a corporation to the mix for legitimate tax savings.

Green NFH CPA Darren Neuschwander and tax attorney Roger Lorence contributed to this blog.

 


A key update on trading entities and management companies

May 6, 2014 | By: Robert A. Green, CPA

Prior to 2014, we suggested that business traders organize as an unincorporated sole proprietorship, or for additional tax benefits like adjusted gross income (AGI) deductions for health insurance and retirement plan contributions, trade in partnership tax structures.

With 2014 guidance from the IRS on self-employment income (SEI) for traders, we pivoted our entity strategies to recommend S-Corps, or adding a C-Corp to a partnership, for the health insurance premium and retirement plan deductions. We’ve been fine tuning our new entity strategies since January and here’s an important update.

Starting in 2014, we suggest business traders use entities in one of three ways:
1. Partnership tax return: Trade in a general partnership or multi-member LLC filing a partnership return and focus on the health insurance premium deduction and the 100%-deductible “elective deferral” portion of an Individual 401k plan ($17,500 for 2014, plus the $5,500 catchup provision for over age 50). While it’s now harder (Note 1) to achieve targeted SEI for these AGI deductions, it’s still possible in some limited situations. But it’s very unlikely that one can achieve a tax-efficient 20% profit sharing retirement plan deduction, too.

If you don’t need these AGI deductions, the partnership tax structure alone works fine. In most states, a general partnership or LLC can elect S-Corp status at a later day, generally by March 15 of a current tax year.

2. Dual-entity solution: Trade in a general partnership or multi-member LLC filing a partnership return and add a C-Corp or S-Corp to the mix as a second entity (a management company). Providing you have sufficient trading gains, it’s possible to receive a maximum 20% profit-sharing retirement plan deduction in either the C-Corp or S-Corp.

If you are in a top individual tax bracket (39.6%), and want to take advantage of lower C-Corp federal tax rates (15%) on the first $50,000 of C-Corp net income — perhaps you’re in a tax-free state for C-Corps and/or you want a medical reimbursement plan which only C-Corps may have — then consider a C-Corp for your second entity. Form an LLC or corporation and you can choose between C-Corp or S-Corp tax treatment within 75 days of inception (by filing a Form 2553 S-Corp election).

If this isn’t your case and there are limited (or no) “stealth” taxes (such as material minimum taxes or franchise taxes) on the S-Corp in your state, you may prefer an S-Corp for your second entity. (See additional tax rules for S-Corps below).

How do you get income into the management company? The management company should own a small percentage of the trading partnership to bring trader tax status to the partnership level. The management company can charge a reasonable administration fee, perhaps $1,000 or $2,000 per month, but not more as that would be unreasonable. (Formalize administration fee agreements early on).

The C-Corp can also get a profit-allocation (carried interest) in the partnership agreement (perhaps 5% to 30%), which can provide the additional income needed to maximize a retirement plan deduction. The profit allocation clause in the partnership agreement is better than a C-Corp owning a higher percentage of equity, as you don’t want partnership trading losses allocated to a C-Corp where there is no immediate tax relief to the owner. Capital losses are limited in C-Corps to a 3 year carryback and 5 year carryforward. That’s not a problem with an S-Corp as the management company, as the S-Corp passes losses to the owner’s individual tax return.

3. S-Corp: Trade in an S-Corp tax structure. Have a base salary for covering the health insurance premium deduction, even if you have trading losses, although profits look better. If you have sufficient profits, make a tax-deductible retirement plan contribution after year-end. Start with the 100%-deductible Individual 401k elective deferral of $17,500. If you have large trading gains, increase payroll in December for a performance-based bonus and then do a 20% profit-sharing retirement plan contribution, totaling up to $33,500 on top of the elective deferral amount. The total defined-contribution retirement plan deduction limit is $51,000 (or $56,500 with the over age 50 catchup provision).

Consider a defined-benefit plan instead of a defined-contribution plan. The defined-benefit plan tax-deductible contribution limit is $210,000 for 2014 on salary determined by an actuary which could be as low as $100,000. Huge savings!

If you use an S-Corp, read Note 2: S-Corps have tax challenges.

Payroll tax compliance is not a big deal for traders
Payroll is not a big deal for a simple trading or management company with spousal or single ownership. Paychex.com can handle all your payroll tax compliance needs and the total cost is around $650 per year.

The Paychex service includes quarterly payroll tax returns (Form 941), the annual payroll tax return (Form 940), state payroll tax returns, and federal unemployment insurance with FUI tax of under $50 for the owner/trader. In most states, the trader/owner is exempt from state unemployment insurance and state workmen’s compensation.

One benefit is you can withhold taxes from payroll in December and have them attributed to being made throughout the year. Take advantage of this tax loophole to reduce quarterly estimated tax payments during the year. Benefit from hindsight and use of the cash flow.

Hedge funds use partnerships for trading, and S-Corps for their management company
Partnerships are the best tax vehicle for a trading business and that’s why hedge funds use a partnership structure in the U.S. (General partnerships and limited partnerships file partnership tax returns and so do most LLCs.) A hedge fund manager uses a management company to charge management fees and to arrange health insurance and retirement plan deductions for the owner/managers and other employees.

Partnership tax returns are more favorable vs. S-Corps on owner basis and allocation of income and loss rules. Partnerships allow “special allocations” with hedge fund managers often getting profit allocation, otherwise known as “carried interest.” By default, hedge funds use investor-level accounting with net asset value (NAV) and profit and loss allocated to each partner for only when they are owners. That’s not the case with S-Corps, as explained below.

Medical reimbursement plans in C-Corps
A C-Corp may have a medical reimbursement plan (MRP), whereas pass-through entities (partnerships and S-Corps) may not for more than 2% owners — and attribution rules apply to spousal owners.

Medical reimbursement plans generally require a minimum of a two-person group health insurance plan arranged on the C-Corp entity level. Group health insurance plan participants generally have a minimum work requirement of 30 hours per week as formal employees under ACA.

If you already enrolled in an individual health insurance plan compliant with ACA, you may have trouble making changes before the enrollment period for 2015, although a new entity and group plan is like changing a job and that may allow for changes mid-year. Check with a state health insurance broker.

If a MRP doesn’t work out for you, perhaps consider a Health Savings Account (HSA). Some HSAs are compliant with ACA. You can arrange a HSA deduction with a trading partnership, S-Corp or management C-Corp. With an HSA, you can increase your health insurance premium deduction by the HSA contribution ($6,550 for a family, plus $1,000 for over age 55 for 2014).

Bottom line
There is no easy tax-structure solution for business traders. While a sole proprietorship is good for deducting business expenses, it’s a red flag with the IRS and you can’t have health insurance and retirement plan deductions in connection with trading gains (with the exception of members of a futures exchange trading futures on that exchange). Every trader’s facts and circumstances are different based on income levels, marital status, state residency including community-property rules if applicable, capital, health insurance coverage, goals for retirement plan contributions, and more.

It’s best to consult with Robert A. Green, CPA about which business tax and entity plan makes most sense for you. Maybe you don’t qualify for trader tax status (TTS) and should be an individual investor. Or maybe you do qualify for TTS and should start off as a sole proprietor. Keep in mind that after April 15, it’s too late for sole proprietors to elect Section 475 MTM treatment, whereas new entities may elect Section 475 MTM within 75 days of inception. Perhaps an S-Corp trading company works well for you and you don’t expect any basis and distribution tax issues (Note 2). Or perhaps you’re better off with a partnership or dual entity solution including a C-Corp or S-Corp for the management company. Our job is to come up with a plan where the benefits far exceed the cost and complications. Entities are a very important part of a successful business trading plan, so it’s certainly worth the time and effort to get it right!

Footnotes

1. New IRS guidance on self-employment income
It’s harder to arrange AGI deductions for health insurance and retirement plans in connection with “earned income” from administration fees received from the trading business filing a partnership tax return — with the administration fees reported on a an individual tax return Schedule C. With partnerships, the new IRS guidance requires individual owners to reduce SEI — the administration fee income — by their share of trading business expenses passed-through from the same partnership.

With the S-Corp and C-Corp, compensation is not reduced by a share of trading business expenses and that’s why it’s more tax efficient for health insurance and retirement plan deductions. (For more, see “New IRS guidance on SE tax deductions affects partnership AGI-deduction strategies.”)

2. S-Corps have tax challenges
S-Corps do not allow special allocations, so you can’t have profit allocations (carried interest). S-Corps can’t have foreign partners or C-Corp partners.

With S-Corps, the default allocation method is annual net profit and loss calculated on a “pro-rata share” basis. The rule requires per-share, per-day basis, based on ownership percentages. If the annual net income is $100,000 and partner B owned 50% for 100 days only, that’s his allocation — 100/365 x 50%. Never mind that the company may have lost money during his ownership period.

For example, if a new owner is admitted on July 1 and the S-Corp had large net trading gains in the first half of the year and losses in the second half, the new owner is allocated his pro rata share of annual net profit and loss. Conversely, with a partnership the default allocation is based on only the period of ownership so new owners don’t get a share of profits outside of their ownership period. There is an S-Corp election to fix this, but it’s crude.

Closing of the books method election: For the previous example, consider making a “closing of the books” method election on the S-Corp dated June 30. That closes the books on June 30 and reopens them on the date the new owner is admitted on July 1. To qualify for this election, the S-Corp owner must dispose of their entire interest during the year or dispose of more than 20% of their ownership interest. Every owner must consent as well. This issue is not common for retail traders, as they generally don’t admit new partners.

Some traders want a profit allocation so they must trade in a partnership structure and the S-Corp won’t work for them as a trading vehicle. One example is when a parent contributes 100% of capital and the son or daughter trader wants a profit allocation based on new high-net profits.

S-Corp basis ordering rules
Although IRS regulations for S-Corps are intended to prevent double-taxation on income or double tax benefits on losses, the unintended consequence is added tax compliance work and in some cases suspended (deferred) losses if they exceed stock and debt basis and acceleration of taxes on distributions in excess of stock basis. This is not a problem for our firm in tax compliance work as our professional software handles these issues automatically.

The basis ordering rules require a specific order in how you calculate your individual S-Corp basis: increases first followed by decreases.

1. Increase by capital contributions;
2. Increase by non-separately stated income (includes Section 475 MTM net ordinary trading gains);
3. Increase by separately stated income (includes portfolio income and net capital gains);
4. Increase by tax-exempt income (includes muni bond interest);
5. Decrease by distributions of cash and FMV of property;
6. Decrease by non-separately stated losses (includes Section 475 MTM net ordinary trading losses and trading business expenses);
7. Decrease by separately stated items of loss or deduction (includes net capital losses and investment expenses);
8. Decrease by non-deductible expenses (50% of meals deduction).

There is a permanent election to change to move non-deductible expenses up one notch above losses. But while that may help in the short-term, it could hurt over the long-term as you must carry over these losses to future years, which will reduce basis.

Tips for using the S-Corp structure
Keep it simple and avoid financing your S-Corp with debt, which brings up debt basis issues. . When you contribute money to the S-Corp, it’s best to treat it as equity, not debt.

In most cases, even if your S-Corp has debt on its books, it’s not debt basis for you unless you are personally set back by it. A personal guarantee doesn’t count until you make a payment to the lender. Conversely, partnership owners are credited with basis for their share of certain partnership debt.

Margin lending is technically not considered debt. With margin, the broker grants the trader additional buying power on securities. If the trader incurs a decrease in account value in connection with the “borrowed positions,” the broker issues a margin call requiring the account holder to deposit more cash into their account. While the margin call itself could be deemed a debt, the account holder generally pays the additional cash immediately or the broker unwinds part of the margined positions. Generally, either the S-Corp has sufficient cash on hand to meet the margin call, or shareholders contribute more capital to meet the call. A note payable is not recorded on the S-Corp books and it’s not debt financing, which means there’s unlikely to be suspended losses due to margin calls.

Suspended losses can happen if the S-Corp borrows actual funds from a third-party who is not a shareholder, and the S-Corp incurs a loss in excess of shareholder equity. In that case, the shareholder’s loss may exceed their stock and debt basis and they would have a suspended loss. For example, say an S-Corp obtains a credit card, purchases equipment and does not pay off the balance right away. A personal guarantee on that card is not shareholder debt basis. Another example is if the S-Corp borrows money from an outside third-party or family member. To avoid these situations, the shareholder should borrow the money individually and then contribute it to the S-Corp as equity or debt to have stock or debt basis.

If you do have debt on the S-Corp, make sure you have sufficient profits to distribute before making a distribution. You need to have good interim accounting on trading gains, losses and expenses. If you take a distribution in excess of your stock basis — effectively benefiting personally from tapping into debt-financed funds — that may trigger capital gains income and related capital gains taxes on the excess distributions. (Debt basis doesn’t count for distributions.)

Are you worse off with an S-Corp trading business vs. a partnership or sole proprietorship structure? Only if you have suspended losses caused by third-party debt that is not shareholder debt basis. That’s rarely the case for most business traders. Sole proprietors need to be “at risk” for losses deducted on a Schedule C and that generally is the case. Form 4797 ordinary losses using Section 475 have similar at risk rules as the Schedule C and they are almost always met by traders. Partners in partnerships have suspended losses when their Form K-1 losses exceed their capital account and share of certain partnership debt. So the answer is no, the S-Corp works fine for most business traders.

Many self preparers and local accountants don’t properly comply with the S-Corp basis ordering rules which can lead to complications and extra taxes. When our firm helps form your trading business as an S-Corp, we recommend our tax compliance service to handle basis and distribution related issues right.