Category: Proprietary Trading Firms

Some Proprietary Traders Under-Report Income

June 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.

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

Independent contractors
Profitable independent contractor (IC) proprietary traders receive a 1099-Misc for “non-employee compensation.” Sole proprietors use a Schedule C to report revenue and deduct business expenses. Schedule C net income is subject to federal and state income taxes, and self-employment (SE) taxes.

Reinvesting earnings are taxable income
Prop traders generate trading gains on their sub-trading account. At the end of a defined period, usually monthly, the firm presents them with a choice: Request a fee payment (distribution of earnings) or reinvest income in their sub-trading account. 

Some prop firms only include fee payments on annual tax form 1099-Misc. They don’t include reinvested earnings. That’s a problem: In the above scenario, reinvested earnings constitute “constructive receipt of income,” which should be reportable income. 

This firm’s prop traders are likely under-reporting income since many will inadvertently or purposely overlook reporting reinvested earnings on Schedule C. Taxpayers are responsible for reporting their correct income, even income that should be included on 1099s but is not.

Constructive receipt of income
In the June 2004 issue of Strategic Finance Magazine: “Constructive Receipt and the Substantial Restrictions Limitation,” Charles E. Price, Ph.D., “Treas. Regs. Sec. 1.451-2 explains that a taxpayer need not have physical possession for an amount to be included in gross income. Income that is set aside for the taxpayer, credited to an account, or otherwise made available is constructively received by the taxpayer. If the taxpayer’s control is subject to “substantial limitations or restrictions,” however, the income isn’t considered to be received.”

“Constructive receipt requires an unqualified vested right to receive income – there can be no condition, limitation, or restriction that prevents the taxpayer from having unrestricted access to his or her money without penalty. The taxpayer, however, can’t waive a present right to receive income— in other words, the taxpayer may not “turn his back” on income that is already earned. But if the taxpayer requests deferral of payment prior to receiving an unqualified vested right to income, constructive receipt doesn’t occur.”

“The key to recognition or deferral is an unrestricted present right of the taxpayer to control the disposition of the income. If substantial limitations or restrictions hinder the taxpayer’s right of access to income, then recognition can be deferred. Taxpayers who seek to defer income recognition must avoid an unqualified right to control that income.”

The trader’s income is set aside and credited to his sub-trading account for his benefit.

 The trader receives an unrestricted, present right to control the disposition of the income, so income deferral is inappropriate.

Example:
A prop trader pays $5,000 as a deposit or expense to a prop trading firm, and the firm gives them a limited power of attorney to trade a sub-trading account containing $25,000.

In month 1, the trader earns $1,000. (Generally, a prop trader receives around 70% of trading gains in the form of non-employee compensation.) The sub-trading account balance is now $26,000. 

The firm offers the trader a distribution (fee payment) of $1,000, but the IC may decline (turn his back on income) and reinvest the $1,000 in the sub-trading account.

After a few additional months with trading gains, the sub-trading account balance is $30,000 containing: reinvested earnings of $5,000, $25,000 of firm capital, and no fee payments to the trader. The firm decides to allocate another $25,000, so the trader is now trading a sub-account with $55,000.

 At the end of the calendar year, the account balance is $65,000 containing trader earnings of $15,000, $50,000 of the firm’s capital, and no fee payments to the trader. 

In the above example, the firm we spoke with would not issue a 1099-Misc because they did not pay fees during the year. The trader’s $15,000 of reinvested earnings meets the IRS definition of a constructive receipt of income, so the firm should report it on a 1099-Misc.

The IRS holds the trader responsible for reporting $15,000 of revenue on Schedule C whether or not the prop trading firm issues a correct 1099-Misc. 
The IRS may also assess a tax penalty to the firm for under-reporting on a 1099-Misc.

Losses of reinvested earnings
Assume the same facts as in the above example; only the trader has $6,000 in trading losses in December. That leaves an account balance of $59,000, containing trader earnings of $9,000, $50,000 of the firm’s capital, and no fee payments.

It may be acceptable to net the losses against the income by issuing a 1099-Misc for $9,000. Otherwise without netting, the 1099-Misc should be for $15,000, and the prop trader can report a $6,000 business bad-debt deduction on Schedule C. Firms should provide traders’ with accounting for reinvested earnings.

Initial deposits
Aspiring traders have two choices: Open a retail trading account or join a prop trading firm.

Retail traders place a deposit with a broker-dealer. If they want to day trade securities, four or more times in five business days, they need “pattern day trading” (PDT) privileges allowing a 4:1 margin and the minimum account size is $25,000. Otherwise, a retail trader is limited by Reg T margin rules to a 2:1 margin.

Many securities traders can’t afford $25,000, and they are drawn to prop trading firms offering higher leverage with less money required upfront. Some prop trading firms ask prop traders for a deposit or another type of payment. Some firms use murky accounting and tax classifications to avoid calling it a “deposit” because they are non-customer broker-dealers who may not accept deposits. Only customer broker-dealers accept deposits. Non-customer broker-dealers also have lower capital requirements and less regulatory scrutiny versus customer broker-dealers.

Some prop trading firms classify initial deposits and reinvested earnings as education expenses or other service expenses, reporting revenue for these payments in the firm’s books and records. But, there are conflicts with sales materials and other paperwork referring to the payments as a deposit or a share of capital.

If a prop trader loses an initial deposit, he can report a business bad-debt deduction on Schedule C, provided they have entered into an independent contractor agreement for rendering trading services.

For other tax tips for prop traders, read Green’s 2016 Trader Tax Guide, Chapter 12 Proprietary Trading.

 Darren Neuschwander, CPA, contributed to this article.

Webinar June 21 & Recording: Proprietary Trader Tax Treatment & Recent Developments

 

Traders: Good And Troubling News In Poppe Ruling

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

Click to read Green's blog post

Click to read Green’s post on Forbes

In light of the William F. Poppe vs. Commissioner court case, there’s good news for retail traders on the volume of trades needed to qualify for trader tax status.

There’s also troubling news. The IRS denied Poppe his Section 475 election because he could not prove compliance with the two-step election process. Traders should be more diligent in documenting their election. The consequence was that instead of deducting his $1 million trading loss as an ordinary loss, Poppe was stuck with a $3,000 capital loss limitation and a capital loss carryover.

The court construed Poppe’s proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.

Qualification for trader tax status
The Poppe court awarded trader tax status (TTS) with 720 trades (60 trades per month). That’s less than our 2015 golden rule calling for 1,000 trades per annum on an annualized basis. Poppe seems to have satisfied our other golden rules on frequency, holding period, intention to run a business, serious account size, serious equipment, business expenses, and more. Plus, Poppe had a good background as a stockbroker.

In some years, Poppe was a teacher and part-time trader, fitting trading into his schedule. It helped that Poppe made a lot of money trading in a few years in comparison to his teacher’s salary.

Botched Section 475 election
Poppe had large trading losses ($1 million in 2007) for which he claimed Section 475 ordinary business loss treatment rather than a puny $3,000 capital loss imitation against other income. But like other recent tax court cases (Assaderaghi, Nelson, Endicott, Holsinger and Chen), the court busted Poppe for either lying to the IRS about making a timely Section 475 election or making a valid election but not being able to prove it to the IRS. Poppe never filed a required Form 3115 to perfect the Section 475 election, which begs the question: Did he ever file an election statement on time?

The case opinion states that Poppe intended to elect Section 475 for 2003 and he filed his 2003 tax return late in 2005 omitting a required 2003 Form 3115. Poppe’s tax preparer reported 2003 Section 475 trading gains on Schedule C. That’s incorrect: Section 475 trading gains are reported on Form 4797 Part II ordinary gain or loss. This botched reporting indicates to me that Poppe’s tax preparer did not understand Section 475 tax law and it probably buttressed the IRS win.

Many traders are in the same predicament as Poppe and should do their best to document the election filing in case the IRS challenges it later on. We document the process for our clients and ask them to document their filings, too. Send yourself an email with the relevant facts as email has a timestamp. Safeguard a copy of the election and Form 3115 in your permanent files.

One learning moment in the Poppe case is how to properly make a timely Section 475 election and to avoid pitfalls in botching the election process.

Section 475 tax loss insurance
By default, investors and traders in securities and Section 1256 contracts have capital gain and loss treatment, as opposed to ordinary gain or loss treatment. Capital losses offset capital gains without limitation, but a net capital loss is limited to $3,000 per year against other income with the remainder of capital losses carried over to the subsequent tax year(s).

Traders qualifying for TTS may file a timely election for Section 475 ordinary gain or loss treatment (on securities only or Section 1256 contracts, too). Generally, traders prefer to retain Section 1256 treatment with lower 60/40 capital gains rates. Section 475 exempts traders from wash-sale loss treatment on securities and capital loss limitations. It’s known as “tax loss insurance” since it allows full business ordinary loss treatment comprising NOLs generating NOL tax refunds.

A sole proprietor (unincorporated) trader makes an individual-level Section 475 election. A proprietary trading firm or hedge fund makes an entity-level Section 475 election. A partner in a proprietary trading firm or hedge fund cannot override the firm’s Section 475 election or lack of an election made on the entity-level.

Warning: Don’t botch the election
Botching the election empowers the IRS to deny use of Section 475 serving up a simple win for the IRS in tax court. Even when a taxpayer properly makes a Section 475 election, an IRS agent may challenge his or her qualification for TTS, which pulls the rug out from under using Section 475. (Each tax year TTS must be assessed as a prerequisite to using Section 475.)

Section 475 election two-step process
The first step is for the trader to file a timely election statement early in the current tax year to prevent the trader from using hindsight about the election later.

An “existing taxpayer” (who filed a tax return before) must file an election statement with the IRS (that means “external”) by the due date of the prior year tax return not including extensions: April 15 for individuals and partnerships and March 15 for S-Corps. (Note that in 2017, the partnership due date changes to March 15.) Attach the Section 475 election statement to the tax return or extension filing. I suggest documenting this first step in your books and records including emailing a copy to yourself and your accountant. Don’t count on the IRS for keeping a copy of the election statement.

An existing taxpayer’s second step is to file a Form 3115 (Change Of Accounting Method) with appropriate Section 481(a) adjustment by the due date of the election-year tax return including extensions. The complex Form 3115 must be filed in duplicate: one copy with the timely filed tax return and a second copy to the IRS national office.

Example of existing taxpayer: A sole proprietor trader files a 2015 Section 475 election by April 15, 2015, attaching the election statement to his 2014 federal tax extension filed on time by mail. (You can’t attach an election to an e-filed extension.) Second step: The accountant prepares a 2015 Form 3115 to accompany the 2015 Form 1040 filed by Oct. 15, 2016 with a valid extension filed by April 15, 2016.

Why the two steps? So taxpayers can make a very simple election filing with little hindsight but to allow sufficient time to prepare a complex Form 3115 with the tax return filing after year-end.

Common errors with Section 475 elections
Many local accountants are confused about the two-step process. Some think only one step is required: either filing the Form 3115 in lieu of the election statement, or the election statement as part of a Form 3115 filing with the tax return. They don’t comply with both required steps and that botches the election.

Section 475 “new taxpayer” exception
There is an important exception to the election process for “new taxpayers” such as a new entity. A new taxpayer may file the Section 475 election statement within its own books and records (internally) within 75 days of inception of the new entity.

Existing taxpayers who miss the external 475 election by April 15 should consider forming a new entity to make an internal Section 475 election within 75 days of inception, which is later in the year. A new taxpayer “adopts” Section 475 from inception as opposed to changing its accounting method so they don’t have the second step of filing a Form 3115 with Section 481(a) adjustment (converting realization/cash method to MTM on Jan. 1).

The entity provides better flexibility in making, revoking, and ending Section 475 elections with closure of the entity. With fewer steps to follow, the internal election for new taxpayers is a better choice for prevailing with the IRS.

Poppe’s errors on Section 475
Poppe was not able to verify the external 475 election statement (step one) or a Form 3115 filing (step two). It wasn’t just a question of being late on a Form 3115 filing, Poppe never filed a Form 3115 and he was an existing taxpayer individual.

Traders should file the external Section 475 election statement with certified return receipt. But that may not be enough because it only verifies a mailing, which also contains the tax return or extension. The IRS recognized this problem and suggests that taxpayers include a perjury statement on Form 3115 stating they filed the 475 election statement on time.

Is there any relief from the IRS?
My partner Darren Neuschwander, CPA spoke with an IRS official in the Form 3115 area a few years ago who said the IRS had granted some relief to a few traders providing they were only a little late with their Form 3115 filing and they filed the election statement on time. The IRS official pointed out there is no relief for filing the initial election statement late.

But Poppe was not a little late — he never filed a Form 3115, even with the case being heard years later. It’s wise to file Form 3115 on time per the written rules and not rely on hearsay about possible relief from IRS officials, which may no longer be granted after the Poppe decision. Consult your trader tax advisor.

Poppe’s mental incapacity argument didn’t work
The Poppe case shows that it doesn’t work to claim reasonable cause on noncompliance due to mental incapacity if the taxpayer can’t demonstrate the same mental incapacity in a job, business, or trading. Poppe tried to raise this issue for special relief and the IRS said no because he wasn’t mentally impaired as a teacher and as an active trader.

Per Thomson Reuters, “Poppe argued that his actions met the requirements of the ‘substantial compliance’ doctrine, under which perfect compliance with a tax provision isn’t required. But the Court said that the substantial compliance doctrine does not apply to the Code Sec. 475(f) election and that, even if it did, Poppe failed to meet many of Rev Proc 99-17 ‘s requirements and thus hadn’t substantially complied.”

Proprietary trading account or disguised customer account?
In 2007 (the IRS exam year), Poppe lost $1 million trading with a proprietary trading firm that cleared through Goldman Sachs Execution & Clearing (GSEC). This is the tax loss at the center of this case.

On his original tax return filing, Poppe reported this loss (assumed) on Schedule E page 2, as an ordinary loss flowing through to him as a partner in a partnership. If the proprietary trading firm qualified for TTS and filed a timely Section 475 election on the firm level, then trading losses allocated to partners would have ordinary loss treatment.

Poppe attached a partner Schedule K-1 to his tax return even though it is not required. But during the exam, the IRS was unable to find Poppe’s K-1 in the partnership tax return filings where it is required to be attached. This begs the question: Did Poppe fabricate his own Schedule K-1? That would be illegal. Or did the firm present Poppe with a Schedule K-1 only to retract it in their partnership tax filing later on? (IRS computers match K-1s reported on partner’s individual tax returns with partnership tax filings looking for incorrect reporting.)

Prop trading firm arrangements, agreements, tax treatment and regulatory issues are murky. Perhaps Poppe never formally signed the prop trading firm’s LLC Operating Agreement. The case states Poppe couldn’t satisfy the IRS that he was a partner in the firm. If not an LLC member, perhaps he was an independent contractor, which is the second business model for proprietary trading firms.

Poppe claimed he was a Class B member of the firm. Generally, the main owners (Class A members) are allocated firm-wide trading losses on their K-1s since they own the firm’s capital in their capital accounts, which provide tax basis for deducting trading losses. Generally, Class B members don’t have capital accounts so they aren’t allocated losses since they wouldn’t have tax basis to deduct losses, which would then be suspended to subsequent years when they might have capital.

Instead of paying into firm capital, Class B members pay “deposits” to the firm. This is where the confusion mainly lies. The firm applies these deposits to cover the prop trader’s trading losses incurred in a firm sub-account. Prop traders are entitled to deduct lost deposits as business bad debts, which are ordinary business losses. Perhaps Poppe should have considered lost deposit bad debt tax treatment instead of using an incorrect K-1 and later relying on an alleged Section 475 election as a retail individual trader.

I’ve been covering the proprietary trading industry since the late 1990s. Around 2000, some people questioned whether proprietary trading firm arrangements were really “disguised” retail customer accounts. Reg T margin rules allow 4:1 margin on pattern day trader (PDT) customer accounts requiring a $25,000 minimum account size. Otherwise, retail investors are limited to 2:1 margin on securities. The big attraction of proprietary trading firms is they offer proprietary traders (LLC members or independent contractors) far greater leverage (greater than 10:1 in some cases) on their deposits made with the firm. Some proprietary trading firms have minimum deposit amounts as low as $2,000.

If the firm’s profit sharing arrangement is more than 80% sharing to the prop trader, FINRA’s Regulatory Notice 10-18 issued to clearing firms stated it’s one of several signs it may be a disguised retail customer account. Read my June 2010 blog post FINRA’s notice to prop traders. Poppe had 90% profit sharing and perhaps that led the IRS to conclude it was a disguised retail customer account. GSEC is a popular clearing firm for proprietary trading firms and I don’t believe it services individual retail customers. Goldman Sachs brokerage firm has high standards for opening individual retail customer accounts.

The Poppe opinion states: “The parties stipulated that all transactions and capital in the GSEC account belonged to petitioner (Poppe).” Perhaps the parties preferred this tact so they could ague the case over Poppe’s alleged Section 475 election as a retail trader. In my view, the word “stipulate” means the parties agreed on facts as a pre-condition to negotiating a settlement. But it’s not necessarily the true facts.

Should prop traders file Section 475 elections as a backup position in case the IRS later considers them a disguised retail customer account? I imagine plenty proprietary trading firms and prop traders are in tax controversy (exams, appeals or tax court) now and I suggest they consider contacting our CPA firm for help soon.

Bottom line
I’m happy to see a new trader tax court case moving the goal posts back to 720 trades from 1,000. That opens the door for more traders. I am not surprised that another trader (and his accountant) botched the complex Section 475 election process and later tried to bamboozle the IRS about it in order to get a huge tax benefit. Proprietary trading firm arrangements with prop traders are murky and the IRS may turn up the heat on them both soon.

For more information, check out T.C. Memo. 2015-205.

Darren Neuschwander CPA contributed to this blog post.

FINRA’s Notice To Prop Traders

June 22, 2010 | By: Robert A. Green, CPA

Are FINRA, the SEC and others about to pounce on day prop trading firms? 

In April, FINRA’s released its Regulatory Notice 10-18, which includes guidance on master and sub-account arrangements. This document has prompted much debate since its release. 

Over the past decade, regulators prodded the prop-trading industry to move away from engaging prop traders as independent contractors. Instead, prop traders were asked to join the firms as LLC members.

A person trading a firm’s capital should either be an employee (as in Wall Street banks and brokerage houses) or an owner of the firm. Regulators tried to clean up the low-hanging fruit, preferring licensed brokers to join prop trading firms organized as broker dealers. Many are “non-customer” broker dealers meaning they don’t any business with retail customer accounts. Customers can have up to 4:1 margin as pattern day traders per Reg T margin rules. Prop traders are only limited within the firm, so many can have 10:1 or greater leverage, making prop trading quite attractive.

One major bone of contention is the issue of deposits. Employee prop traders rarely pay deposits on Wall Street, and only pay them occasionally in prop trading firms. Independent contractor and LLC member prop traders usually are requested to pay deposits. The deposit size has a direct (although somewhat hidden) connection to how much leverage they are afforded by the firm and how much their share of trading profits will be (60 to 100 percent depending on deposit size).

In prop trading firms, these deposits are rarely treated as LLC member capital contributions, and they’re connected to a sub-account’s trading performance and used to cover sub-account trading losses. When traders leave a firm, most agreements demand they pay back losses in excess of their deposit accounts.

Another concern is the issue of “special allocations” of sub-account trading profits. Special allocations seem to push the envelope of what the IRS allows in partnership returns. The Wall Street employee prop trader may have a sub-account to trade and track performance, and then receive a bonus based on performance — perhaps 50 percent compensation (the Wall Street model), whereas many prop traders automatically receive 99 or 100 percent of the trading profits. We understand FINRA may regard the latter payouts as indicative of a beneficial owner — perhaps a disguised customer account. Some firms may need to change to 80/20 splits to keep muster.

While some prop trading firms offer the employee-model option with 60/40 or 50/50 payouts, some still rely on the LLC or contractor model, paying out more than 80 percent. Firms seem to make money on services, or rebates. In my opinion, rebates are a form of collecting commissions, and if this is the case, the broker should be registered as a commission broker dealer.

The IRS allows special allocations in partnership returns, which an LLC files. Special allocations stand up to IRS scrutiny if they follow the money. It’s odd to me that prop traders who are Class C or D members, yet don’t share in firm-wide profits and losses and even their own losses, can still receive 99 or 100 percent of their LLC class profits on their own sub-trading account. Traders eat what they kill.

The FINRA notice seems bent on identifying “beneficial owners” hidden in prop trading firm master and sub-account relationships. Beneficial owner is a legal term where specific property rights (“use and title”) in equity belong to a person even though legal title of the property belongs to another person. This often relates where the legal title owner has implied trustee duties to the beneficial owner.

Over this past decade on this story, many have used the term “disguised customer accounts.” Are FINRA and the SEC looking to force retail traders back into a customer account peg instead of a prop trading firm peg? If so, those traders would be forced back into regular retail compliance including 4:1 pattern day trader rules and more.

The FINRA notice list asks clearing firms to spot these red flags and then take action. Many clearing firms may not be able to see these red flags, because prop trading firms structure things in a somewhat deceptive manner. For example, if a prop trading firm has a large brokerage account and many domestic and foreign traders, those details (including trader names) may be hidden from the clearing broker. Sub-accounts may be labeled with non-identifying (by legal name) information like just account numbers.

Here, I’ve included the the FINRA Notice 10-18 list in bold, and my comments thereafter. The notice states a firm will be on inquiry notice if:

1. Sub-accounts are separately documented and/or receive separate reports from the firm.Firms document exact sub-account activity in reports often given to each prop trader.

2. Firm addresses the sub-accounts separately in terms of transaction, tax or other reporting.Firms summarize these reports into year-end tax reporting, including either 1099-Misc, Schedule K-1 or W-2.

3. Services provided to the sub-accounts engender separate surveillance and supervision risk management. Firms often oversee each trader and compare their risk, gains and losses to deposit amounts, offset losses against deposits, and request deposit replenishment. This isn’t always seen by clearing firms.

4. Firm has financial arrangements or transactions with the sub-accounts, or separate account terms, that reasonably raise questions about beneficial owners. Traders receiving 99 or 100 percent payouts on trading gains seem like beneficial owners. If the firm was truly an owner too, wouldn’t it receive a bigger share of the trading gains? Arrangements vary by sub-account and trader.

5. Sub-accounts incur charges for commissions, clearance and similar expenses. Yes. Firms charge traders for various services including education, tools, desk charges, commissions (in some cases), rebates and other services.

6. Firm has evidence of financial transactions or transfers of assets or cash balances that would reasonably evidence separate beneficial-ownership of the sub-accounts. In my view, that refers to traders making deposits, although they are rarely credited to sub-accounts. Most firms are somewhat cute about keeping the deposits off to the side and not transferring them into the sub-accounts.

7. The firm is aware of or has access to a master account or like agreement that evidences that the sub-accounts have different beneficial owners. The firm’s LLC agreement, listing Class C and D prop traders is this type of document, in my view.

8. The firm has evidence that a party maintaining a master/sub account arrangement has interposed sub-accounts that have or are intended to have the effect of hiding the beneficial-ownership interest. If the sub-accounts have account numbers without names of the traders, that could be deemed a form of hiding, I presume.

9. The number of sub-accounts maintained is so numerous as to reasonably raise questions about beneficial ownership. Many prop trading firms have numerous sub-accounts, so this is a concern too.

10. Items 3, 4, 5, 6, 8 and 9 would not apply in the case of a registered IBD or a bona fide IA arrangement described in the Notice. In my opinion, a prop trading firm organized as a non-customer broker dealer (BD) can’t claim it’s an IBD per this notice, as IBDs have customer accounts. FINRA is telling clearing firms they can rely on the customer IB to have handled compliance on its customers. Even if the broker dealer is registered as a customer BD, the prop traders in question aren’t treated by those firms as customers, so I don’t believe the firms can avail themselves of these exceptions in connection with application of this FINRA regulatory notice. I believe these prop trading firms can’t claim IA status either, as the traders are active and not passive investors, and the firms generally aren’t registered investment advisors.

FINRA is asking clearing firms for help here and they may not see these red flags. Although, if they have huge accounts with these firms, compliance forces them to understand their client and know what’s happening behind the scenes. To claim ignorance is probably not acceptable either.

If FINRA and/or the SEC examines these prop trading firms, they can easily see these red-flag items. What action will they take from there? Can prop trading firms restructure their business models to share more with their traders, so the traders aren’t deemed beneficial owners? Will that please the regulators? Does FINRA equate beneficial owners with “should be” customer accounts? It will be interesting to see how the IRS will react, too. 

Prop trading firms in the grips of the regulators may consult their lawyers for protection. They may disclose their pertinent information and not tell traders everything they should learn on their own. Attorneys representing prop trading firms are expected to handle their clients’ needs by law and not necessarily serve the public’s interest. It’s always a good idea to consult your own attorney, and not necessarily the attorney representing your prop trading firm.

We help many prop traders on their tax planning and preparation and consult with them on big picture items too. In the past, many traders decided to continue prop trading because the leverage and access was attractive and they took payouts to retain as little money as possible at risk in the firms. Keep your eyes and ears open on this story.