Category: Entities

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

forbes_logo_main

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

forbes_logo_main

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.


New IRS guidance on SE tax deductions affects partnership AGI-deduction strategies

January 14, 2014 | By: Robert A. Green, CPA

Update on March 4: Potential solution for 50/50 HW partnership returns. In general, we recommend 50/50 as that is how married couples generally share property. Pay administration fees during the year and if you need more cash flow, the husband and wife can reinvest capital to finance ongoing fee payments. Consult with us about your administration fee agreements and payment schedules.

Update on Feb. 21: With a two-spouse partnership return, you can maximize AGI deductions (health insurance and retirement plans) with the active-trader spouse owning just 1% (or a minority) of capital, rather than 99% (or a majority) of capital. However, that may not be feasible or wise considering joint property issues. In these cases, it’s better to consider an S-Corp election, or add a C-Corp, so the partnership can remain 50/50. Active traders owning 99% (or a majority) should consider changes soon. 2014 S-Corp elections are due by March 15, 2014. Consult with us about these changes.

In Green’s 2014 Trader Tax Guide, see Chapter 7 Entities & Chapter 8 Retirement Plans for our updated strategies on entities and retirement plans.

Business traders reporting an administration fee on an individual tax return Schedule C paid from their trading business partnership in order to unlock AGI deductions for health insurance and retirement plan contributions need to consider some changes as a result of new IRS guidance. The IRS released draft instructions to Form 8960 (Net Investment Income Tax) in January 2014. The instructions state that trading business expenses should be deducted against self-employment income (SEI), and any excess amount generating negative SEI may be deducted against Net Investment Income (NII). These draft instructions are based on the IRS’s final NII regulations released in December 2013.

Business traders using an S-Corp or C-Corp with payroll rather than a partnership administration fee are mostly unaffected by this new IRS guidance. But partnerships need to consider these suggested solutions. We’re adopting this new guidance for 2013 tax returns and subsequent years.

The partnership fee/AGI-deduction strategy can still work on some partnership tax returns.
Prior to 2013, the simplest entity for a husband and wife was a general partnership filing a partnership tax return. To unlock AGI deductions for health insurance and retirement plans, the partnership paid an administration fee to the trading owner’s individual Schedule C, creating the earned income needed for the AGI deductions. But the trading business expenses passed through from the partnership — including the fee payment — were not included in SEI. With new IRS guidance requiring an SEI deduction for partnership expenses, it’s harder to achieve the SEI that is necessary for purposes of maximizing these AGI deductions.

Consider this example of a husband and wife 50/50 general partnership or LLC filing a partnership tax return for 2013. The partnership has trading business expenses of $20,000 before paying an administration fee to the husband, who is the active trader (assume the wife is non-active). Before the new IRS guidance, the partnership could pay an administration fee of $30,000 to the husband to cover AGI deductions for health insurance (close to $12,000) and Individual 401(k) elective deferral ($17,500). Now, the partnership needs to gross up the fee to cover the husband’s 50% share of partnership Schedule E SEI deductions. Therefore, the partnership needs to pay a fee of $80,000 to have a net SEI of $30,000. Fifty percent of the trading partnership’s loss (equal to $50,000 in this example) from trading business expenses ($100,000) is allocated to the husband. (The $100,000 is comprised of the $20,000 expenses and $80,000 fee.) The wife’s 50% allocation with negative SEI has no effect, as SEI and SE tax is calculated separately.

This change is not as simple as it may sound. The partnership needs to generate more income to justify a higher fee — an increase of $50,000 — and it needs the cash flow to execute it. If the husband owned a lower percentage of the partnership, the fee increase can be lower. But, in many HWGP entities, the non-active owner holds 1% of profit and loss, and that is a problem for this potential solution. They should consider changing to 50/50 or even 20/80.

If you want net SEI of $30,000, calculate the fee payment as follows. Trading expenses x allocation percentage = a negative SEI. You want to add an amount to get to $30,000 positive SEI and divide it by the other spouse’s allocation percentage to get the administration fee amount. For example, with 20/80, the negative SEI is: $20,000 x 20% = ($4,000). To get to the target $30,000 SEI, pay $34,000. Next, gross up $34,000 by dividing it by 80% which equals the administration fee of $42,500 (and is only $12,500 more than the $30,000 target). Total expenses are $62,500 ($20,000 expenses + $42,500 fee). Total expenses x the 20% allocation = a negative SEI of ($12,500) + the administration fee of $42,500 = target SEI of $30,000.

If the partnership approach doesn’t work for you, arrange salary not administration fees
The key issue for claiming health insurance and retirement plan deductions is to arrange these employee benefits in connection with a salary. The IRS does not allow partnership tax returns to pay a salary (payroll) to owners; it requires guaranteed payments or administration fees. The solution is to convert an LLC or a general partnership to an S-Corp, or add a C-Corp as a 1% partner, because an S-Corp or C-Corp pay salary to owner/employees.

An existing general partnership or multi-member LLC filing a partnership return can elect to be taxed as an S-Corp for 2014, by filing a federal Form 2553 S-Corp election by March 15, 2014. Some states rely on the federal form and other states have their own election form. Very few states don’t conform to federal “check the box regulations” allowing general partnerships or LLCs to elect S-Corp tax treatment. Consult with us about whether an S-Corp election is beneficial for you, and allowed in your state.

These solutions are less disruptive and lower in cost than opening, and closing entities. You can keep your existing trading business, including its trading accounts and bank accounts, in place.

S-Corp tax treatment is inappropriate for a hedge fund or trading company with special allocations like “carried-interest” to owners as that is considered a second class of equity and is not allowed. These types of partnerships should consider adding a C-Corp as a 1% owner.

A general partnership or multi-member LLC filing a partnership tax return can add a new C-Corp as a 1% owner of the partnership. There are few changes for the partnership: It keeps filing a partnership tax return and pays the C-Corp an administration fee and 1% or more allocation of profits. The C-Corp then has sufficient income to pay the owner a salary to unlock C-Corp-level employee benefits for health insurance and retirement plan contributions.

C-Corp owners have added benefits that are not available with partnership and S-Corp returns. The owner can have a medical reimbursement plan, which increasingly is an attractive idea considering higher deductibles and out-of-network health costs under ObamaCare plans. You can also shift individual income to lower C-Corp tax rates or operate the C-Corp close to break even if state corporate taxation is a concern.

Retirement plan changes
The other change you need to make is converting an individual-level retirement plan to the entity level. Salary-based retirement plans require entity-level retirement plans. This is fairly easy to accomplish, however some brokers may be confused about a general partnership electing S-Corp treatment, so consult with us.

For 2013, if you used a partnership and you reclassified distributions to administration fees, you may want to reclassify them back to distributions so you don’t need to file a 2013 Form 1099-Misc. by the end of February. But if you do file the 1099-Misc., it may not unlock many AGI deductions per the new guidance: The fee payments included in the partnership loss offset the fee income for both gross income and self-employment income purposes. It depends on the fee recipients share of the partnership loss.

If there is insufficient 2013 net self-employment income, you can’t fund retirement plans, so make sure there is no excess retirement plan funding for 2013 subject to IRS penalties. If you already excess funded a plan for 2013, withdraw those excessive funds as soon as possible to avoid penalties.

There’s time to fix 2014, but no time to fully fix 2013
Traders using partnerships can rearrange their tax affairs to get all the tax breaks for 2014 and subsequent years, but 2013 is a transition year so they get left holding the bag on fewer tax breaks such as no or limited AGI deductions based on their trading businesses. They do keep their business expense treatment, Section 475 and other trader tax benefits.

Unfortunately, you can’t reclassify administration fees to payroll, as payroll is a formal contemporaneous filing. It’s not a big deal to handle payroll with an outside firm like paychex.com.

Good news/bad news
This seems like positive news for business traders and other taxpayers, since SEI deductions are more valuable than NII deductions. SE taxes include FICA and Medicare tax, whereas Net Investment Tax (NIT) only includes the 3.8% Medicare tax. Deducting trading business expenses against self-employment income first is generally a good thing and we are not against this new guidance.

Sole proprietor traders with other earned income activities will generally be happy with this new IRS guidance. They can now deduct their trading business expenses from SEI and pay less SE tax. But they also have less earned income for retirement plan calculations.

The bad news is the new guidance causes issues for business traders using AGI-deduction strategies for health insurance and retirement plan contributions arranged through trading business partnership tax returns. Those strategies were constructed based on trading business expenses not being deductible against SEI. With the new IRS guidance, the partnership loss on Schedule E — increased by the administration fee payment — is also deductible against SEI, so the administration fee on Schedule C cannot generate positive SEI needed for the AGI deduction for a 99/1 HWGP.

Our prior position excluding trading business expenses from SEI
To date, we’ve taken the position that trading business expenses — like related trading business gains and losses — should be excluded from SEI.

While Section 1402 (SE tax rules) first state that Section 162 “trade or business” expenses for individuals and partnerships are deductible against SEI, they go on to exclude trading capital gains. IRS publications, trader tax court cases and Website statements all clearly state that business trading gains and losses are excluded from SEI. Unfortunately, we don’t see trading business expenses discussed specifically anywhere. Leading tax publishers have also said this matter was unclear in the law.

We’ve taken a conservative position: Since trading gains and losses are excluded from SEI, so should their related trading business expenses. When tax law is unclear, it’s often appropriate to turn to general tax concepts and theory, which includes a matching concept. If the income is non-taxable, generally the expenses to generate that income are also non-deductible. That’s how it works with tax-exempt income — the investment fees and margin interest to generate that income are non-deductible.

To clarify this matter, we asked an IRS official involved with the new NII regulations about these questions. The IRS person unofficially said the IRS thinks trading business expenses offset SEI first, and then NII. He pointed to example 4 in “Reg §1.1411-9. Exception for self-employment income,” which was released in December. We conclude it’s prudent to adopt this new guidance on 2013 tax filings. We believe our tax filings for 2012 and prior years are correct based on existing tax law at that time.


Dangerous entity scams targeting traders, part 3: Education expenses are a problem in dual-entity schemes

March 3, 2010 | By: Robert A. Green, CPA

Stay clear of promoters advocating expensive dual-entity schemes in order to deduct educational costs; it costs much more than the related tax benefits and we offer a better solution. 

Here’s the problem: Aspiring traders often want to take online trading classes before setting up either a trading business (qualifying for trader tax status) or an active investment activity (which may fall short of trader tax status). 

As we pointed out in “Dangerous entity scams targeting traders, part 2,” it’s very difficult to achieve a tax deduction for pre-business and investment education expenses. If you qualify for trader tax status first, and then take trading classes, they probably qualify for business deduction treatment. If you qualify for trader tax status soon after the education classes, a reasonable amount of education may be squeezed — under limited conditions — into Section 195 start-up costs, which have limited business deductions after business commencement. If you don’t qualify for trader tax status before or after, Section 212 investment expenses are allowed, but they can’t include Section 274(h)(7) expenses: including one-week education classes, and travel to classes, seminars, trade shows and conventions. Online classes and longer course schedules may qualify for Section 212 investment expense treatment. 

We think the promoters flout these basic rules about education deductions and they make blanket promises to traders offering full business deduction treatment for all pre-business or even pre-investment education classes for up to 18 months before the trader even starts active trading. We explained some education expense problems in part 2; here we discuss using dual-entity schemes to cover up these problems. 

C-corps allow tax-free fringe benefit plans like a Section 127 education assistance plan for employees, whereas pass-through entities, including general partnerships, LLCs and S-Corps do not for owners of 2 percent or more of the equity. Dual-entity promoters usually don’t even offer a Section 127 education assistance plan. But in the event you are offered a one, read on to understand how they work, and learn why they aren’t recommended in our view. 

Section 127 and C-corps
A Section 127 plan is limited to an exclusion of income in the amount of $5,250 per year. But few traders are able to adhere to Section 127’s strict rules, plus the expenses of the scheme are greater than the tax benefits anyway. The trader will wind up owing taxes rather than saving taxes. However, it’s useful to understand the rules of Section 127 because they point out the pitfalls traders are falling into with these schemes. 

Traders pay for education costs in the range of $5,000 to $25,000. If a C-corp reimburses an individual for this education cost, it’s considered a fringe benefit to the trader and therefore taxable income to that individual. According to tax law, the individual trader is the one who is getting the benefit of education, so it’s as if the corporation paid the individual the benefit of the education (as a dividend or as salary, either of which are taxable to the individual). 

The individual is entitled to exclude up to $5,250 from income per year only with a C-corp and Section 127 plan in place before the education was initiated. If a trader was reimbursed for $15,250 of education, the trader would have $10,000 of net taxable income and that excess could not be deferred to later years under the Section 127 plan. It’s very rare that a trader would have a C-corp and Section 127 plan in place before attending classes, so the taxable income would be $15,250 if there is no Section 127 exclusion. 

Many traders don’t realize they are falling into a tax trap here. If they executed one of these schemes, the IRS (during an exam) can force the trader to report taxable income for the entire amount of the education expenses reimbursed by the C-corps, leading to high back taxes, interest and penalties.

The promoters claim the second entity LLC can bail them out of this problem, yet they are wrong again. The scheme usually calls for the LLC to pay the C-Corp an administration fee — intended to cover the C-Corp’s education-related expenses — which is treated as taxable compensation to the individual trader owner/employee. 

Many promoters claim the LLC doesn’t need to qualify for trader tax status and as we explained in part 1, they are wrong. Without trader tax status, the LLC has Section 212 investment expense treatment passed through to the individual owner. There are several tax problems in this case. The individual winds up with taxable income from the C-corp and a restricted investment expense passed through from the LLC partnership tax return. 

Add it up and the individual has taxable income not fully offset by investment expenses — limited to 2 percent of AGI and added back for AMT. That leads to higher taxes. The IRS also may bar the Section 212 expense treatment, considering it a disguised education deduction that doesn’t qualify for Section 212 because it fails under Section 274(h)(7) travel education rules. 

Even if the LLC qualifies for trader tax status later in the tax year, in the best-case scenario, the trader has zero change in gross income. The individual trader may be able to offset his taxable income from the C-corp by a business deduction passed-through from the LLC. Again, we think the IRS may challenge this scenario as a sham transaction. 

Examples and more details about Section 127 plans
First, it’s important to note that Section 212 (investment expense treatment) applies only to individuals, not corporations. So, can an individual simply use a C-corp to navigate around the education tax-deduction problems discussed in part 2 of our articles?

Suppose a C-corp established in February 2010 pays pre-business education expenses soon thereafter in February 2010 either directly or by reimbursement to the owner/manager of the C-corp. The trader forms a husband-and-wife LLC which qualifies for trader tax status in October 2010. The trading-business LLC pays the C-corp an administration fee in December 2010 to cover the C-corp’s expenses (including an attempt to deduct pre-business education) and generate a sufficient small profit for the C-corp. 

The problem with the C-corp setup is the individual trader is benefiting from the education, so it’s as if the corporation paid the individual for the education (as a dividend or as salary, either of which are taxable to the individual). The individual must either find a legal way to deduct the education expenses or report its value as income. 

As we discussed earlier, Section 127 allows an employee to exclude up to $5,250 per year for education provided by an employer. This applies both to reimbursements received from an employer as well as the fair market value of educational assistance paid or provided directly by the employer. (This is the case only if the requirements of Section 127 are followed, including the existence of a written plan.) If the trader is a shareholder but not an employee of the C-corp, we would argue that all of the education should be taken into income.

Here is how the C-corp, LLC and individual owner should be handled tax-wise. The C-corp reports revenues for the administration fee received from the LLC and deducts officer salary paid to its owner/manager for the education expenses. The individual may exclude up to $5,250 per year; expenses paid or reimbursed over this amount are taxable income. For this reason, most C-corps will probably limit education-related salary payment to $5,250 per year. 

If an individual takes educational courses costing more than $5,250 in one year, he can’t defer the excess to later years. The individual must take the excess into income, which can be a real downside to this idea. 

So far, it sounds like under limited conditions, a trader might benefit from a C-corp to deduct and exclude up to $5,250 of educational assistance per year. But keep in mind it’s really only the first year of a trading business for which this strategy sounds interesting. Once a trading business is established, all business education is fully deductible by the LLC or sole proprietor trader as Section 162 business expense treatment. After the first year, there’s no cap on business education deductions. 

Technically, this Section 127 educational expense strategy — under perfect and rare conditions — could deliver just the initial year’s education exclusion limit of $5,250. But, it costs much more than the related tax savings on the $5,250 exclusion (figure around $2,000 with a 40 percent federal and state marginal tax rate). Plus, the IRS could challenge this scheme. 

In a perfect world, the C-corp is formed before paying for education courses, allowing a deduction for educational expenses, which are reported as salaries to the individual employee/owner. The LLC must qualify for trader tax status later in the year, and then it can pay the C-corp an administrative fee equal to the cost of educational expenses (plus more for a reasonable profit), so that the C-corp can offset the fee income with the educational deduction. The employee will have to recognize income to the extent the educational expense exceeds $5,250. The total benefit to the scheme is just $5,250, if all things are handled correctly.

In reality, this Section 127 education expense scheme fails because it’s rarely deployed in the correct order or proper manner. The C-corp, Section 127 plan and payroll all must be setup and deployed in advance of the education courses being taken. Usually traders don’t know about this plan until after they have started their trading classes. 

Even if a trader knows about this before taking course, it’s not worth pursuing in our view. Remember, the best course of action if you are knowledgeable of the rules in advance is to qualify for trader tax status before taking education classes and then receive an unrestricted business deduction. 

Even if the IRS accepts the scheme, the cost/benefit savings don’t add up. This scheme costs thousands of dollars, more in cost than the tax-savings on the $5,250 Section 127 education expense exclusion. Keep in mind that the C-corp has state filing fees and annual report charges (which vary by state), double-taxation (since the C-corp needs to show a reasonable profit), and there are professional fees for preparing the C-corp tax returns, the payroll tax returns and setting-up and maintaining the Section 127 fringe-benefit plan. This scheme is very profitable for promoters but not traders. 

Our tax solutions for deducting pre-business education costs deliver much greater tax benefits, under an easier safer, and wiser approach. Plus, our costs are far lower too. 

Our solution
Take your education classes and then consider your options with no up-front commitments. When a trader feels he will qualify for trader tax status in the near future, at that time the trader can form one simple pass-through entity like a general partnership or LLC. A second C-corp is not needed. The trader also doesn’t need payroll (taxes and compliance costs) or the formation of a Section 127 plan. Our solution has entity formation costs and preparation fees for one simple entity; dual entities double the related costs.

You can attempt to squeeze the pre-business education costs — as we suggested in part 2 of this series — into Section 195 start up costs. Perhaps the pre-business education amount is $10,000. The first $5,000 of start-up costs is a first-year expense election and the balance is deductible over 15 years. That’s a greater deduction than the $5,250 Section 127 limit in year one only. 

Our solution has some risks in the IRS accepting the education as part of Section 195 (see part 2). The IRS won’t challenge the type of education in the Section 127 plan — as it’s not a factor — but again the cost of the dual-entity Section 127 scheme is far greater than any potential tax savings, so it’s better to skip that approach entirely. 

Bottom line
Why should traders spend thousands of dollars before taking classes for a scheme that delivers fewer tax benefits compared to our solution? Our solution can be deployed after-the-fact, when a trader knows he has a viable trading business. Plus our plans cost far less and deliver many more tax breaks.


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Close