Entity Solutions

Forming an entity can save active traders significant taxes.

Most traders eligible for trader tax status (TTS) begin as sole proprietors (unincorporated businesses). They use a Schedule C as part of their tax return to deduct business expenses. TTS traders can elect Section 475 MTM for 2023 by April 18, 2023, to avoid wash sales losses and the $3,000 capital loss limitation. Section 475 gains are also eligible for the qualified business income (QBI) deduction. We covered sole proprietors in earlier chapters.

If the activity in the entity qualifies for TTS, a pass-through entity, including a partnership or S-corp, can offer several additional tax-saving strategies.

An S-Corp can arrange employee benefits, including deductions for health insurance and retirement plan contributions. Sole proprietorships and partnerships cannot do employee benefits for owners.

In about 25 states, S-Corps and partnerships can do a SALT cap workaround to convert non-deductible state and local taxes (SALT) into business expenses.

S-Corps and partnerships can ring-fence (segregate) TTS with Section 475 on the entity level versus investments held on the individual level averting IRS confusion. Hold Apple stock as a personal investment and safely trade Apple options with 475 MTM on the entity without the IRS trying to apply MTM to the investment in Apple.

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.

Newly-formed 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 18, 2023, for 2023. 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 Form 3115 after filing an external election with the IRS. It’s also easier for an entity to exit TTS and Section 475 MTM than for a sole proprietor.

Prior capital-loss carryovers on the individual level aren’t lost if you form a pass-through entity; these still carry over on Schedule D. The new entity can pass through capital gains if the taxpayer opts to use up individual capital loss carryovers with entity gains by skipping the entity Section 475 MTM election. Then, the entity can elect Section 475 MTM in a subsequent tax year.

There are costs for tax compliance (a separate entity tax return is required), payroll compliance for S-Corps, and minimum taxes in some states. An entity is more formal than a sole proprietorship.

Before forming an entity in your resident state, be confident you’ll be eligible for TTS. Try to estimate the benefits versus the costs before creating an entity to be sure it makes sense.

For more information, see Green’s Trader Tax Guide, Chapter 7, Entity Solutions.