Entity Solutions

Forming an entity can save active traders significant taxes.

Using an entity can save active traders significant taxes. Business traders solidify trader tax status (TTS), unlock employee-benefit deductions (health and retirement), gain flexibility with a Section 475 election and revocation, limit wash-sale losses with individual and IRA accounts, and ring-fence trading vs. investments. Pass-through entities can also do the SALT cap workaround strategy in twenty-plus states. 

Sole proprietors

An individual trader eligible for trader tax status (TTS) is a sole proprietor filing a Schedule C. The trader is entitled to deduct business, start-up, organization, and home office expenses and elect Section 475 MTM for 2022 by April 18, 2022. 

SMLLC disregarded entity

Traders don’t have customers or investors; they trade for their accounts. If they are concerned with the asset protection of their trading funds, they might want to consider a single-member (SM) LLC taxed as a “disregarded entity.” That means they remain a sole proprietor if eligible for TTS. An SMLLC/disregarded entity is a tax nothing in the eyes of the IRS, so the TTS trader files as a sole proprietor. Consult an attorney about asset protection and other legal issues. 

S-Corp for employee benefits

Suppose a TTS trader wants to deduct health insurance premiums and retirement plan contributions. In that case, they need an S-Corp to pay a salary at year-end, providing the necessary earned income. Sole proprietor traders cannot pay the owner compensation, so they cannot have health insurance and retirement plan deductions. It’s challenging to achieve self-employment income with a trading LLC/partnership. Trading income is unearned income. 

Ring-fencing solution

A spousal-member LLC/partnership, or LLC/S-Corp, can provide a ring-fencing solution, separating TTS/Section 475 trades from investments in securities. Many traders hold significant investment positions in securities and trade equity options around those positions to manage risk and enhance income. Combining trading and investing in the same brokerage account can disqualify eligibility for TTS, as the holding period on investments drags the average over the 31-day requirement. Even if you separate trading and investments in different brokerage accounts, the IRS, during an audit, can reclassify investments as trades if you elect Section 475 mark-to-market accounting. That could happen if you overlap, i.e., you invest in Tesla stock and trade Tesla options. In that case, it’s unsafe to elect 475 because the IRS can apply mark-to-market accounting and ordinary income tax rates to the investment positions in Tesla stock, thereby ruing income deferral and long-term capital gains rates. To safely use Section 475, consider a ring-fencing solution: An entity for TTS/475 and make investments on the personal level. 

SALT cap workaround strategy

Twenty-plus states enacted SALT cap workaround solutions. These state laws allow pass-through businesses, including partnerships and S-Corps, to pay state income taxes on the entity level and report the state taxes as a business expense on Schedule K-1. The state allows the owner a tax credit on their tax return for state taxes. That converts non-deductible SALT payments over the $10,000 SALT cap into a business expense deducted from gross income.

Pass-through tax return

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. An S-Corp with owner wages unlocks the phase-out range for increasing the qualified business income (QBI) deduction on Section 475 net income less TTS expenses. Make PTE payments for the SALT cap workaround strategy. 

Section 475 election

Section 475 trades are exempt from wash sales and the capital loss limitation. A trader might be eligible for the 20% qualified business income QBI deduction on Section 475 net income, less TTS expenses if under the taxable income threshold of $340,000 married or $170,000 for other taxpayers (2022 limits).

Entities help traders elect Section 475 MTM (ordinary-loss treatment) later in the tax year — within 75 days of inception — if they miss the 2022 Section 475 election deadline for individuals on April 18, 2022. And it’s easier for an entity to exit TTS and revoke Section 475 MTM than for a sole proprietor. It’s more convenient for a new entity to adopt Section 475 MTM internally from inception instead of an existing taxpayer who must prepare and file a Form 3115 after filing an external election with the IRS.

Capital loss carryovers

Don’t worry; prior capital-loss carryovers on the individual level aren’t lost if you form an entity; these still carry over on personal Schedule Ds. The new entity can pass through capital gains if the taxpayer skips the Section 475 MTM election to use those capital loss carryovers. Then, the entity can elect Section 475 MTM in a subsequent tax year.

Miscellaneous

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.

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

Consider an Entity Tax Consultation with Robert A. Green, CPA.

Robert A. Green, CPA
CEO, Green & Company, Inc
GreenTraderTax.com