Tag Archives: proprietary

Different Types Of Traders

August 31, 2014 | By: Robert A. Green, CPA

“Trading” is a widely used term covering everyone from the casual investor with a dozen trades per year to the active investor with a few hundred, to the business trader with over seven hundred, to proprietary traders using a proprietary trading firm’s capital, to investment managers trading for their investor clients. Let’s take a look at the various types of traders. 

Casual Investor 

Millions of Americans have online brokerage accounts, and they make a dozen or more trades per year in individual and IRA accounts. They need to deal with cost-basis reporting on securities and make wash sale loss adjustments and tax treatment for various trading products. They can expect to have some issues with consumer tax software and tax storefront services. For example, a local tax advisor may not know where to report forex transactions and how best to handle wash sale reporting on securities vs. 1099-Bs. Starting in 2018, the new tax law TCJA suspended investment expenses, except investment-interest and stock borrow fees.

Active Investor 

Many online traders have several hundred trades per year, but they fall short of claiming trader tax status (TTS). The Poppe tax court approved 60 trades per month, for a total of 720 per year, annualized. Often, active investors have another job or business activity, and they don’t have sufficient time to trade for a living. They have more tax issues than the casual investor, including wash sales between individual and IRA accounts, more complex tax treatment issues as they trade a wider variety of instruments, and keeping a close eye on TTS qualification. With TCJA suspending investment expenses, TTS is more critical than ever before.

Retail Trader with Trader Tax Status

A small minority of online traders qualify for TTS, business expense treatment. They should master the content in our Trader Tax Center, read Green’s Trader Tax Guide, and consider our full array of services targeted to their unique needs. Business traders trade their funds in a retail customer account. With proper tax planning, traders qualifying for TTS can maximize business expense treatment, elect Section 475 MTM ordinary gain or loss treatment (tax loss insurance), and form an S-Corp trading company to unlock employee benefit plan deductions, including health insurance and a retirement plan. In 2018, they may be eligible for TCJA’s QBI deduction, which includes Section 475 ordinary income but excludes capital gains. (Read Trader Tax Status in our Trader Tax Center.)

Pattern Day Trader 

The Federal Reserve coined the term “pattern day trader” (PDT) in connection with its margin lending rules (Reg T) on the purchase of securities on margin. The default margin for a retail account is 2:1. Day traders are allowed up to 4:1 intraday leverage providing they have a PDT account with a minimum securities account size of $25,000. Many PDT accounts never rise to the level of TTS. Skirting PDT rules with an offshore securities broker may lead to trouble. 

Proprietary Trader 

Many traders who can’t meet the PDT minimum account size for securities are attracted to opportunities with proprietary trading firms, who are known to offer traders far greater leverage in return for low deposits or upfront payments. Prop firms invite traders to join their company in one of two ways. Some prop trading firms register as non-customer broker/dealers, and regulators prefer prop traders as LLC members of the firm. These LLC-member traders receive an annual Schedule K-1 with their allocation of net trading gains. Other prop firms interconnect with an education business. After paying for teaching and passing tests, these companies may invite graduates to become independent-contractor (IC) traders earning non-employee compensation reported on an annual tax Form 1099-Misc. Both types of prop traders are eligible for TCJA’s QBI deduction on pass-throughs; an IC prop trader has ordinary income, and an LLC member may receive a share of Section 475 ordinary income. QBI excludes capital gains. There are special rules for writing off deposits, deducting expenses, and more. (Read Proprietary Trading in our Trader Tax Center.)

Investment Managers 

Investment management is when you trade money belonging to investors. As you can imagine, handling other people’s money is a serious business, and there is a vast body of investor-protection law and regulation on securities, commodities futures, and forex. The investment manager may need various licenses and to register with the regulator in charge. (Read Investment Management Services for more information about regulation.) Investment managers handle two types of investors: separately managed accounts (SMAs) and hedge funds (or commodity or forex pools). In an SMA, the client maintains a customer account, granting trading power to the investment manager. In a hedge fund, the investor pools his money for an equity interest in the fund, receiving an annual Schedule K-1 to allocate income and expense. Hedge funds use carried-interest provisions to help investors navigate around the suspension of incentive fees as itemized deductions. (Read Investment Management in our Trader Tax Center.)

For more in-depth information on different types of traders, read Green’s Trader Tax Guide.

Foreign Partners In A U.S. Trading Partnership Can Be Tax Free

August 19, 2014 | By: Robert A. Green, CPA

Non-resident alien traders often ask us these two tax questions:

• “If I open an individual brokerage account in the U.S. to trade securities, futures and forex, will I be liable for U.S. taxes on my trading gains?”

• “If I become a partner in a U.S. proprietary trading firm filing a partnership tax return, do I owe U.S. taxes on my Schedule K-1 income?”

The answer to the first question is no. Trading gains are considered portfolio income which is not effectively connected income (ECI) in the U.S. Generally, non-resident aliens are liable for U.S. tax on income from business and real property in the U.S. There is tax withholding on dividend payments and sales of master limited partnerships (MLPs). There is no withholding in connection with futures or forex trading.

The answer to the second question is more complex. Typically, foreign partners in U.S. partnerships are considered to have U.S. ECI on their Schedule K-1 income. But if the partnership is a trading company — in financial markets, not goods — the income is considered portfolio income, including the partner’s share. Typically, U.S. partnerships withhold taxes on foreign partners, but that is not required if the foreign partner only has portfolio income not subject to U.S. tax. It gets more complicated with dividends in the partnership, since there was no withholding of dividends tax for the share owned by the foreign partner.

864(b) Trading Safe Harbor
According to research by tax attorney Mark Feldman, if the partnership is doing just forex trading (or other types of trading in stock, securities or futures), then it is probable that a foreign partner will not be subject to U.S. tax based on the following:

Generally, under Section 875(1), if a partnership is engaged in a trade or business in the U.S. (“ETB”), a nonresident alien partner of the partnership is automatically ETB. However, Section 864(b)(2)(A)(ii)&(B)(ii), provides an exception to ETB if a nonresident alien trades for his own account—even if through a principal office located in the US. It seems that this exception overrides the general rule of Section 875(1); after all, a deemed presence under 875(1) should be no worse than an actual presence in a principal office.

See FSA 199909004: Section 1.864-2(c)(2)(iii) provides rules for determining whether the taxpayer’s principal office is in the United States. . . . However, we note that the Taxpayer Relief Act of 1997, P.L. 105-34, section 1162(a), removed the requirement that the partnership have its principal office outside the United States. Therefore, for taxable years beginning after December 31, 1997, even if it was determined that USP [US partnership, with its principal office in the US] was a trader rather than investor in stocks and securities, FC [foreign corp, which was a partner in USP] nevertheless would not be subject to tax on its distributive share of USP’s capital gains due to the section 864(b)(2)(A)(ii) safe harbor. After December 31, 1997, FC would fail the trading safe harbor in section 864(b)(2)(A)(ii) only if either FC or USP was also a dealer in stocks or securities.

The FSA is presumably basing itself on this language in Treas. Reg. 1.864-2(c)(2)(ii) (which was not yet amended to reflect the repeal of the principal office requirement, otherwise known as the Ten Commandments, in 1997):

Partnerships. A nonresident alien individual, foreign partnership, foreign estate, foreign trust, or foreign corporation shall not be considered to be engaged in trade or business within the United States solely because such person is a member of a partnership (whether domestic or foreign) which, pursuant to discretionary authority granted to such partnership by such person, effects transactions in the United States in stocks or securities for the partnership’s own account or solely because an employee of such partnership, or a broker, commission agent, custodian, or other agent, pursuant to discretionary authority granted by such partnership, effects transactions in the United States in stocks or securities for the account of such partnership. This subdivision shall not apply, however, to any member of (a) a partnership which is a dealer in stocks or securities or (b) a partnership (other than a partnership in which, at any time during the last half of its taxable year, more than 50 percent of either the capital interest or the profits interest is owned, directly or indirectly, by five or fewer partners who are individuals) the principal business of which is trading in stocks or securities for its own account, if the principal office of such partnership is in the United States at any time during the taxable year.

Presumably, after the regulation is amended, part (b) of the last quoted sentence will be removed. Also, PLR 8850041 (not reliable for precedent) says that Section 864(b)(2)(B) “commodities” include forex.

Bottom line
“It’s my understanding that a non-U.S. person that is a member of a prop trading firm is subject to the exemption in 864 for trading for your own account provided that the prop trading firm is not a dealer,” tax attorney Roger Lorence says. “In some cases, a prop trading firm is a member of a commodities exchange or a securities exchange, but this is as a customer member. The prop trader receives better fees and commissions, but is not actually making a market or otherwise trading. So long as the prop trading firm is a customer member, then there’s no ETB issue. However, there can be state issues where the state diverges from the federal rules of 864.”

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.