Entity Solutions

Forming an entity can save active traders significant taxes.

Forming an entity can save active traders significant taxes. Business traders solidify trader tax status (TTS), unlock employee-benefit deductions for health insurance and a retirement plan, gain flexibility with a Section 475 election and revocation, and limit wash-sale losses with individual and IRA accounts. For many active traders, an entity solution generates tax savings in excess of entity formation and compliance costs.

TCJA created a 20% deduction on domestic qualified business income (QBI) in pass-through businesses, including sole proprietorships, partnerships, S-Corps, and trusts. For a TTS trading business, QBI likely includes Section 475 ordinary income, whereas it excludes capital gains. Proposed reliance regulations state that a TTS trading business is a specified service activity, so the taxable income cap of $415,000 married/$207,500 other taxpayers apply for allowing a QBI deduction. The QBI deduction has a phase-out range below the income cap of $100,000 married and $50,000 other taxpayers. There is also W-2 wage and property limitations applied in the phase-out range. (See Chapter 17.)

An entity return consolidates trading activity on a pass-through tax return (partnership Form 1065 or S-Corp 1120S), making life easier for taxpayers, accountants, and the IRS. It’s important to segregate investments from business trading when claiming TTS, and an entity is most useful in that regard. It’s simple and inexpensive to set up and operate.

Additionally, entities help traders elect Section 475 MTM (ordinary-loss treatment) later in the tax year — within 75 days of inception — if they missed the individual MTM election deadline on April 15. And it’s easier for an entity to exit TTS and revoke Section 475 MTM than it is for a sole proprietor. It’s more convenient for a new entity to adopt Section 475 MTM internally from inception, as opposed to an existing taxpayer who must prepare and file a Form 3115 after filing an external election with the IRS.

Don’t worry, prior capital-loss carryovers on the individual level aren’t lost; they still carry over on individual 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. After using up capital loss carryovers, the entity can elect Section 475 MTM in a subsequent tax year.

Business traders often use an S-Corp trading company or an S-Corp or C-Corp management company to pay salary to the owner in connection with a retirement plan contribution and health insurance deduction. Employee-benefit deductions are difficult to arrange in a partnership trading company.

Trading in an entity can help constitute a performance record for traders looking to launch an investment-management business. Finally, many types of entities are useful for asset protection and business continuity. A separate legal entity gives the presumption of business purpose, but a trader entity still must achieve TTS for business deductions and employee benefits.

Excerpt from Green’s 2019 Trader Tax Guide Chapter 7 Entity Solutions.