State & Local Tax

As a trader operating a virtual business, you can move to a tax-friendly state.

Individual, corporate and estate taxes by state

As a trader operating a virtual business, you can move to a tax-friendly state. For example, if you retire from a job in high-tax California, New York State/City, Massachusetts, or New Jersey, you can move to tax-friendly Texas, Florida, or Washington.

Income taxes: Seven states do not have individual income tax regimes including Texas, Florida, Washington, Nevada, South Dakota, Alaska, and Wyoming. See Tax Foundation’s State Individual Income Tax Rates and Brackets for 2018.

Estate taxes: “Twelve states and the District of Columbia impose an estate tax while six states have an inheritance tax. Maryland is the only state in the country to impose both,” according to Tax Foundation’s Does Your State Have an Estate or Inheritance Tax? for 2018. Many of the states with an estate or inheritance tax are in the northern part of the country.

C-Corp taxes: “Forty-four states levy a corporate income tax. Rates range from 3 percent in North Carolina to 12 percent in Iowa,” according to Tax Foundation’s State Corporate Income Tax Rates and Brackets for 2018.

Trader Tax Battle Of The States

In my 2016 five-part series “Trader Tax Battle Of The States,” I focused on state and local tax systems for S-Corps, LLCs, and partnerships. I mention basic information about individual income tax, estate and inheritance tax regimes.

Watch our Webinar recording: Best, Worst & The Decent Tax States For Traders.

A few states tax s-corps, but traders can reduce it*

An S-Corp is tax-free on the entity level for federal tax purposes, and some states have only small minimum taxes or annual report fees. However, a few state jurisdictions impose higher taxes on S-Corps: On S-Corp net income, Illinois has a 1.5% replacement tax, California has a 1.5% franchise tax, and New York City has an 8.85% general corporate tax. In some of those jurisdictions, a dual entity structure for high-income traders might help: A trading general partnership, which is free of state or NYC taxes, and an S-Corp management company.

Illinois replacement tax: S-Corps and partnerships operating in Illinois are liable for the replacement tax of 1.5% on net income. There’s an important exception applicable to traders: an “investment partnership” is exempt. An investment partnership doesn’t have to file an IL Form 1065 partnership tax return. (See Illinois Income Tax Act Section 1501(a)(11.5).) The investment partnership exception does not apply to an S-Corp. If the trading company files an S-Corp Form 1120-S federal tax return, it must also file an IL Form 1120-ST (Small Business Corporation Replacement Tax Return) and pay the replacement tax. Consider increasing officer compensation to reduce IL replacement tax or use a dual-entity structure.

California Franchise Tax: S-Corps operating in California are liable for the state’s franchise tax of 1.5% on net income. The minimum franchise tax is $800 per year, even in a short year; $800 divided by 1.5% equals $53,333. That means an S-Corp owes franchise tax above the $800 minimum tax after net income exceeds $53,333. Deduct officer compensation and employee benefit plans in calculating net income. General partnerships are not liable for an $800 minimum tax, but LLCs are. Only the S-Corp owes 1.5% franchise tax.

Traders may avoid or reduce the California franchise tax by using a dual-entity solution: A general partnership trading company and an S-Corp management company. Two entities are difficult and costly to administer. But if you expect significant trading gains and are not committed to maximizing the retirement plan as described in the following paragraph, then consider dual entities.

Alternatively, traders can use one entity: an S-Corp trading company. The trader should plan to maximize the Solo 401(k) retirement plan contribution. Based on profits, after deducting officer compensation of $148,000 for the maximum Solo 401(k) retirement plan contribution of $62,000 (over age 50), if the S-Corp’s net income still triggers franchise tax over the $800 minimum tax, then he can increase officer compensation to reduce franchise tax.

Higher wages increase 2.9% Medicare tax on earned income, but that replaces ACA’s net investment tax (3.8% Medicare surtax) on net investment income. Increasing officer compensation above $148,000 does not add to social security (FICA) tax since the social security base amount is $132,900 for 2019.

If a California LLC does not file as an S-Corp or C-Corp, there is an LLC fee based on gross income: $0 if gross income is under $250,000, $900 if under $500,000, $2,500 if under $1 million, $6,000 if under $5 million, $11,790 if over $5 million. Gross income includes net trading gains.

New York City General Corporation Tax (GCT): Taxpayers can have an S-Corp for federal and New York State purposes, but New York City does not acknowledge S-Corps. NYC assesses a general corporation tax (GCT) on S-Corps of 8.85% times net income allocated to NYC. Taxpayers can reduce net income with deductions for officer compensation, health insurance, and retirement plans. However, there is an alternative tax: “8.85% of 15% of net income plus the amount of salaries or other compensation paid to any person, including an officer, who at any time during the taxable year owned more than five percent of the taxpayer’s issued capital stock,” according to NYC CGT Tax Rates.

A dual-entity solution might be better: A trading general partnership, which is exempt from NYC 4% unincorporated business tax (UBT) providing it only has trading income, and not advisory fees or other types of income. The second entity is an S-Corp management company for the health insurance and retirement plan deductions. It reduces NYC GCT, but two companies are more difficult and expensive to operate.

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