Trade In An Entity For Tax Savings And Protection.
Forming an entity can save active traders significant taxes. Business traders solidify trader tax status (TTS), unlock employee-benefit deductions, gain flexibility with a Section 475 election and revocation, potentially qualify for the new 20% pass-through deduction on qualified business income (Section 475), and limit wash-sale losses with individual and IRA accounts. For many busy traders, an entity solution generates tax savings significantly more than entity formation and compliance costs.
Employee benefits: A TTS S-Corp deducts family health insurance premiums (i.e., $20,000), and a Solo 401(k) retirement plan deduction (up to $61,000 in 2018, including the $6,000 catch up provision for age 50 or older). Total employee benefit plan deductions might be $81,000, which leads to several thousand dollars of income tax savings more than payroll tax costs. A sole proprietor or partnership TTS trader cannot have these employee benefit deductions related to trading gains.
20% pass-through deduction: The 2017 Tax Cuts and Jobs Act created a new 20% deduction on qualified business income (QBI) in pass-through businesses, including sole proprietorships, partnerships, S-Corps, and trusts. It’s likely that a TTS trading business has QBI from Section 475 ordinary income, whereas, QBI excludes capital gains. A TTS trading business seems to be a specified service activity with an income threshold of $315,000 married/$157,500 other taxpayers for allowing a QBI deduction. (See Chapter 17 of our guide or blog posts.)
Looks better: An entity return consolidates trading activity on a pass-through tax return (partnership Form 1065 or S-Corp 1120-S), making life easier for you, your accountant, 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. The entity return should work much better for the 20% pass-through deduction, vs. a sole proprietor return with Section 475. TTS generates business expenses, whereas, the new tax law suspends miscellaneous itemized deductions including investment expenses.
475 elections: 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 complex Form 3115 after filing an external election with the IRS.
Avoid IRS havoc: If you trade and invest in substantially identical positions – i.e., trade Apple with Section 475 MTM, and invest in Apple for long-term capital gains – it’s wise to ring-fence trading positions inside an entity account. Without an entity, the IRS could cause havoc: recharacterizing unrealized or long-term capital gains on Apple investments as Section 475 mark-to-market ordinary income. Or, recharacterize Section 475 ordinary losses in Apple trading positions as capital losses. The entity also helps distinguish trading from investments in assessing qualification for TTS.
Seamless transition: Don’t worry, you don’t lose prior capital-loss carryovers on the individual level; they still carry over on your Schedule D. The new entity can pass through capital gains if you skip the Section 475 MTM election to use up those capital loss carryovers. After using up capital loss carryovers, your entity can elect Section 475 MTM in a subsequent tax year.
Asset protection: Many types of entities are helpful for asset protection and business continuity. That might help if you have a signficiant negative balance with a broker. A separate legal entity gives the presumption of business purpose, but a trader entity still must achieve TTS.
For more in-depth information on entity solutions for traders, and which type is best for you, read Green’s 2018 Trader Tax Guide.
Consider our entity formation service.