More people are trading in the stock market as a result of the expansion of online and discount brokerage firms, which has made trading more accessible. Traders cannot, however, utilize some of the tax benefits and asset protection techniques offered to businesses because they are individuals or sole proprietors.
Independent trading can be a means for people to supplement their income or even make a full-time living. But the revenue made by trading is taxable, just like it is in any other venture. Being a successful independent day trader can result in large tax obligations for you. Those who want to actively trade stocks have a few options: they can do it as solo traders or individuals, meet the requirements for trader status, or use a corporate company.
For the active trader, forming a legitimate trading firm will frequently provide the best tax treatment and asset protection.
What You Need To Know
- Those who want to actively trade stocks have a few options: they can do it as solo traders or individuals, meet the requirements for trader status, or use a corporate company.
- Creating a legitimate trading company will frequently offer the best tax treatment and asset protection for the active trader.
- Unless a person meets the Internal Revenue Service’s (IRS) criteria for qualified trader status, all money they derive from trading operations is regarded as unearned or passive income when they file their individual income taxes.
- Create a distinct corporate organization via which you will carry out your trading activities if you are unable to obtain qualified trader status. This will ensure that you are given equivalent tax treatment to a qualified trader.
The tax treatment of traders
The Internal Revenue Service (IRS) says that trading does not count as a business activity. In actuality, all trading-related revenue is regarded as passive or unearned. The IRS says that this is based on the idea that people are investors and that any trading is done to build up long-term capital (rather than to pay for current debts). Because of this, unless a person can obtain merchant status, they will be treated similarly to other people who file taxes.
Contributions to a pension fund or an individual retirement account (IRA) can’t be used to reduce trading income. If you are considered a passive trader, the only benefit is that your trading income doesn’t have to pay extra self-employment taxes. After that, W-2 wage earners get deductions the same way they always have, which is usually just for mortgage interest, property taxes, and donations to charity. Most deductions have dollar amounts that are limited to a percentage of adjusted gross income.
Since trading is not a business activity, the IRS doesn’t let you deduct any of the costs that come with it. The price of needs like training, a trading platform, software, internet connectivity, computers, etc., can be high for most active traders.
Most traders’ biggest problem is that they can’t deduct trading losses from their taxes as much as they’d like to. Only $3,000 more can be deducted from ordinary income after that. Each person is only allowed to use $3,000 of their annual net capital losses against future income.
Tax remedies for traders
Some active traders try to get trader status so that they don’t have to pay taxes this way. (IRS Publication 550 outlines the criteria for obtaining trader status.)
On a Schedule C form, a qualified trader can claim business expenses like costs for entertainment, education, margin interest, and other costs related to trading. Qualified traders can also deduct equipment used in their business under Section 179. Lastly, a qualified trader has the option to make a Section 475(f) election, sometimes known as an MTM election.
Traders who are allowed to use mark-to-market (MTM) accounting can turn their capital gains and losses into regular income and losses. On the last day of the year, all positions are assumed to be sold at market value, and a gain or loss is made up. For the next year, the basis for each of these holdings is set by assuming that they were also bought at market value. At the end of the year, the hypothetical gains and losses are added to the real gains and losses for tax purposes.
Under the MTM system, all losses are deducted in the year they happen because gains and losses are both seen as regular income. With MTM, traders don’t have to worry about the $3,000 net capital loss limits and can deduct all losses in the year they happen. This gives the taxes for the current year the most tax relief possible. Some traders choose MTM because of the 30-day wash sale rule. This rule says that you can’t claim a loss on “substantially similar” stocks you buy within 30 days of selling them.
Qualified Traders as Defined by the IRS
In IRS Publication 550 and Revenue Procedures 99-17 and 99-49, the IRS has set out broad standards that explain the kinds of actions that make trading a business. A person must trade securities full-time and make the majority of their revenue from day trading in order to be considered an active securities trader. The IRS says that a trader is someone who buys and sells a lot of securities to make money from short-term changes in prices.
A trader is someone who makes trades on a regular basis throughout the year in order to make money from the day-to-day changes in the market. They spend a lot of time recording and analyzing deals and methods, and they spend a lot of money operating their firm. Even though it’s not required, most traders who are eligible open and close a number of trades every day and keep their holdings for less than 30 days.
The advantages of qualifying are clear for active traders, but the IRS and courts may interpret these rules in any way they see fit. In actuality, only a small portion of people meet the requirements for this IRS classification.
Establish a separate corporate entity
If you are not eligible for qualified trader status, you can still make sure that you get the same tax treatment by setting up a separate corporation through which you will do your trading. You can get the same tax treatment as a qualified trader without having to meet the requirements by setting up an LLC or limited partnership.
The IRS often gives this kind of legal organization less scrutiny. If someone wasn’t committed to running the business as a business, they probably wouldn’t take the time and money to start a corporation.
After an election, like MTM, has been made, it is quite difficult for people to change their minds. The company can be easily dissolved and reformed if it would be better to change its legal structure or accounting methods.
Success equals more entities
Financial advisors may suggest that traders who are very successful set up a corporate structure with many companies to get the most tax and protection benefits for the business. This sort of legal business structure typically includes a C corporation, which exists to serve as the general partner or managing member of multiple limited liability corporations; the exact structure depends on an individual’s financial objectives. Through a contracted management charge, extra money (often up to 30% of income) can be sent to the corporate entity in order to take advantage of more tax planning opportunities.
Family members may work, for instance, to pay for children’s college costs or to give them money that is not subject to tax. In addition to setting up accounts for Social Security and Medicare, the business can take advantage of tax breaks for wages and education costs. All kinds of elective medical procedures and medical insurance premiums can be paid for with medical reimbursement programs. Transferring retirement funds into a 401(a), a sort of pension fund that accepts annual contributions and cannot ever be accessed by creditors or through a legal claim, is possible with retirement accounts such as individual retirement accounts (IRAs) and 401(k) plans. The objective is to cover as many expenses as you can with pretax money and to reduce your taxable income because the corporation pays taxes on net income.
As the business and the owner are kept apart, this sort of corporate structure also offers good asset protection. Long-term assets can be held by some limited liability companies that are able to use accounting methods that are better for investing. Because each asset is owned by a different legal entity, it is safe from creditors and the person’s legal obligations.
State law, however, controls how much legal protection an individual receives. Due to Nevada’s absence of corporate sales tax, the ability for creditors to amend orders as their sole remedy, anonymity due to not having to disclose owners, and ease of nominating corporate executives, several experts advise establishing the entity there.
Even though there are clear benefits to trading through a complicated legal framework, it can also make a person’s personal life much harder. Trading as a straightforward business is crucial for traders who have been consistently profitable but cannot or do not wish to qualify for trader status.
The extra complexity is a fair trade-off for the benefits of a compound structure if you want to set up a pension fund to defer taxes, pay family members a salary, or get money back for big medical bills without paying taxes. In either case, it is to your advantage to contact financial experts who are familiar with the creation and management of these businesses for traders in order to receive the best tax treatment and legal protection.
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