Tag Archives: entities

great webinar

August 1, 2019 | By: Robert A. Green, CPA

Good afternoon Mr. Green.  Thank you for a great webinar with a no-nonsense straight to the point information.

How To Structure A Trading Business For Significant Tax Savings (TradeStation)

June 27, 2019 | By: Robert A. Green, CPA

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

Join Robert A. Green, CPA, of GreenTraderTax.com for this valuable one-hour presentation.

Webinar hosted and recording produced by TradeStation Securities, Inc. Everyone is welcome; you don’t have to be a client of TS.

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How To Structure A Trading Business For Significant Tax Savings (Interactive Brokers)

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

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

Join Robert A. Green, CPA, of GreenTraderTax.com for this valuable one-hour presentation.

Webinar hosted and recording produced by Interactive Brokers. Everyone is welcome; you don’t have to be a client of IB.

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How To Structure A Trading Business For Significant Tax Savings

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

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

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

Table for choosing a TTS trading business structure

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

How To Avoid IRS Challenge On Your Family Office

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Still Time For Trading Entities To Make Valuable Year-End Tax Moves

November 30, 2016 | By: Robert A. Green, CPA

Forbes published this post.

If you conduct a trading business in an S-Corp and plan on employee benefit plan deductions for 2016, you need to execute certain transactions at year-end. If you have a partnership, there are fewer steps to take.

S-Corp year-end planning for traders

Before the end of the year:

  • Execute and pay officer compensation. Determine compensation based on the retirement plan contribution you want. (You should limit retirement plan contributions to net profits, and not fund plans if you have net losses in the S-Corp. You need this officer compensation to create earned income to have employee benefit plan deductions.)
  • Establish a Solo 401(k) or defined benefit plan (DBP) before year-end. Contribute up to $59,000 in a Solo 401(k) and perhaps up to $200,000 or more with a DBP if you are 45 or older.
  • “Use or lose” an S-Corp accountable plan before year end for reimbursing business expenses paid individually, including home office expenses.

In January 2017:

  • Fund the Solo 401(k) “elective deferral” contribution: Up to $18,000, plus an additional $6,000 catch-up provision, if age 50 or older. Deduct the elective deferral from taxable wages on the W-2. The elective deferral is subject to payroll taxes.
  • For an S-Corp: Add officer health insurance premiums to the officer’s W-2 taxable wages. The amount is exempt from payroll taxes, including FICA, Medicare and state workmen’s compensation. The S-Corp owner/officer should simultaneously take an AGI deduction for health insurance on his or her individual tax return. (Officer health insurance is quirky with an S-Corp).
  • Prepare and e-file W-2s by Jan. 31 (new deadline this year).
  • Prepare and e-file Form 1099-Misc for “non-employee compensation” paid to service providers, including independent contractors, by Jan. 31 (new deadline this year).

For payroll, we recommend a team at www.Paychex.com dedicated to the needs of our trader tax clients using S-Corps. Please contact us for their contact and related information.

To avoid under-estimated tax penalties caused by skipping quarterly estimated tax payments earlier in the year on the individual level, consider increasing tax withholding on officer compensation. The IRS treats payroll tax withholding as being made throughout the year, so that should lower under-estimated tax penalties if you generated most of your trading gains earlier in the year.

The S-Corp needs to qualify for trader tax status (TTS) for the IRS to allow it to have compensation and employee benefit plan deductions, including health insurance and retirement plans. The IRS does not permit an investment company to have these employee benefit plan deductions.

The IRS requires partnerships to treat compensation paid to partners as “guaranteed payments,” and it does not allow partners to have salary run through payroll. But, a trading partnership should not use guaranteed payments since the IRS views it as an investment company. A partnership may pay an administration fee to the owner/trader, but with partnership losses caused by these fees flowing through to the partner, it’s difficult for them to generate self-employment income (SEI). A partner needs SEI to have AGI-deductions for health insurance and a retirement plan. S-Corp losses do not flow through to the owner for SEI purposes, and that’s the reason I recommend the S-Corp structure for traders who want employee benefit plan deductions.

If you have a dual entity structure with trading partnership and S-Corp or C-Corp management company, you should be adhering to written agreements providing for administration fees and or profit allocation. The agreements must represent valid business relationships, operations and work performed.

To learn more, watch our complimentary recording: Year-End Planning For Entities: Payroll, Retirement and Health Insurance. The accompanying worksheet (on the recording page) highlights the differences in a Solo 401(k) vs. a defined benefit plan and tax savings at different levels of income. This content is dated Nov. 12, 2015, and it’s still useful for 2016 year-end tax planning as there are few tax changes from 2015. I expect changes in entity tax strategies with tax reform and tax cuts in 2017, so stay tuned for blog post updates. (Read Traders Likely To Benefit If Senate Rams Through Trump Tax Cuts.)

I suggest our entity clients contact their assigned CPA immediately to get started on valuable tax planning, including executing the above transactions on a timely basis. (Read Many Ways Traders Can Save Taxes Before Year-End. Please don’t wait until late December as we take time off for the holidays.

My partners Darren Neuschwander, CPA and Adam Manning, CPA contributed to this blog post.

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

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

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Traders qualifying for trader tax status need an S-Corp structure if they want tax-advantaged employee benefit plans, including health insurance and retirement, saving thousands in taxes. Conversely, if they use a partnership or sole proprietor structure, traders cannot have employee benefit plan deductions.

An S-Corp is tax-free on the entity level for federal tax purposes, and most states have small minimum taxes on S-Corps. However, a few jurisdictions have higher taxes: On S-Corp net income, Illinois has a 1.5% Replacement Tax, California a 1.5% Franchise Tax, and New York City an 8.85% General Corporate Tax. In those jurisdictions, I recommend a dual entity structure for high-income traders: A trading general partnership, which is free of state or NYC taxes, and an S-Corp management company with a low income and little state or NYC taxes.

Illinois Replacement Tax
S-Corps and partnerships operating in Illinois are liable for IL replacement tax of 1.5% on net income. There’s an important exception applicable to traders:  an “investment partnership” is exempt from IL replacement tax. An investment partnership doesn’t have to file an IL Form 1065 partnership tax return. (See Illinois Income Tax Act Section 1501(a)(11.5)).

The investment partnership exception does not apply to an S-Corp. If the trading company files an S-Corp Form 1120-S federal tax return, it must also file an IL Form 1120-ST (Small Business Corporation Replacement Tax Return) and pay the replacement tax.

California Franchise Tax
S-Corps operating in California are liable for CA franchise tax of 1.5% on net income. The minimum franchise tax is $800 per year, even in a short year. $800 divided by 1.5% equals $53,333. That means an S-Corp owes franchise tax above the $800 minimum tax after net income exceeds $53,333. Deduct officer compensation and employee benefit plans in calculating net income. General partnerships are not liable for an $800 minimum tax, but LLCs are. Only the S-Corp owes 1.5% franchise tax.

New York City General Corporation Tax
You can have an S-Corp for federal and New York State tax purposes, but New York City will disregard your S-Corp tax status and treat it as a C-Corp, a regular corporation. That means New York City will expect your S-Corp to pay General Corporation Tax (GCT) of 8.85% on net income. Reduce net income with deductions for officer compensation and employee benefit plans. If your income is high, you may trigger some “alternative tax,” which requires adding back officer compensation with an alternative tax calculation.

Strategies to limit state taxation
If you have trading gains not exceeding $200,000 per year in Illinois, California, or New York City, it’s okay to use an S-Corp, providing you plan to maximize retirement plan contributions using a Solo 401(k). From the $200,000 trading gains in the S-Corp, deduct the maximum $140,000 of officer compensation needed to unlock the maximum Solo 401(k) plan contribution limit of $53,000, or $59,000 with the over-age 50 catch-up provision. Net income will be low, thereby limiting state or NYC taxes.

If you consistently have trading gains over $300,000 per year in Illinois, California, and New York City, consider a dual entity structure: A trading general partnership, which is free of state or NYC taxes, and an S-Corp management company with a low income and little state or NYC taxes.

The trading company pays the management company monthly administration fees, and a “profit allocation,” which is a share of trading gains. With this income, the management company pays officer compensation and employee benefit plans. The goal is for the management company to have a minor net income to reduce state or NYC taxes. With proper tax planning, tax savings from the dual-entity solution should well exceed tax compliance costs for the two entities.

State and city taxation varies, so consult with a trader tax advisor.

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

Darren Neuschwander CPA contributed to this blog post.