Different Types Of Traders
On this page, we take a look at the different tax matters for casual investors, active traders, business traders, proprietary traders, and investment managers.
“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.
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 types of trading products including securities, futures, other Section 1256 contracts, options, ETFs, ETNs, precious metals, cryptocurrencies, and swap contracts. 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, how best to handle wash sale reporting on securities vs. 1099-Bs, and how to deal with the new 20% deduction on qualified business income (QBI) in pass-through entities. 2017 is the last year investors may deduct investment expenses as the new tax law suspended miscellaneous itemized deductions, including investment expenses, starting in 2018.
Many online traders have several hundred trades per year, but they fall short of claiming trader tax status. 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, dealing with lots of pre-business education costs, more complex tax treatment issues as they trade a wider variety of instruments, and keeping a close eye on qualification for trader tax status.
Retail Trader with Trader Tax Status
A small minority of online traders qualify for trader tax status (TTS), business expense treatment. They should master the content in our Trader Tax Center, read Green’s 2018 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 trader tax status can maximize Section 162 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. Starting in 2018, they may be eligible for the new 20% QBI deduction on a pass-through trading company with Section 475 or Section 988 ordinary income.
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 trader tax status.
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 they admit 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 are inter-connected 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 the new 20% 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. (Read Proprietary Trading in our Trader Tax Center.)
Investment management is when you trade money belonging to investors. As you can imagine, handling other people’s money is 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 for his allocation of income and expense. Investors in hedge funds may be eligible for the new 20% QBI deduction in pass-throughs if the fund has TTS and Section 475 or 988 ordinary income. (Read Investment Management in our Trader Tax Center.)
For more in-depth information on different types of traders, read Green’s 2018 Trader Tax Guide.
We offer professional services to all these different types of traders.