Excerpt from Green’s 2015 Trader Tax Guide. (25%-off coupon at the bottom.)
Forming an entity can save active investors and business traders significant taxes. Active investors can prevent wash-sale losses calculated between their individual taxable investment accounts and IRAs with an entity account. Business traders solidify trader tax status, unlock employee-benefit deductions, gain flexibility with a Section 475 election and prevent wash-sale losses with individual and IRA accounts. For many active traders, an entity solution generates tax savings in excess of entity formation and compliance costs.
An entity return consolidates your 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 trader tax status, and an entity is most useful in that regard. It’s simple and inexpensive to set up and operate.
Additionally, entities help traders elect Section 475 MTM (ordinary-loss treatment) later in the tax year if they missed the individual MTM election deadline on April 15. And it’s easier for an entity to exit trader tax status and Section 475 MTM than it is for a sole proprietor. It’s less expensive and more convenient for a new entity to adopt Section 475 MTM internally from inception, as opposed to an existing taxpayer whom must file a Form 3115 after filing an external election with the IRS.
Don’t worry, prior capital loss carryovers on the individual level are not lost; they still carry over on your individual 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.
Entities provide more flexibility for tax treatment elections. You can form a new entity for a do over on those elections. (See Chapter 2’s “Digging out of a capital loss carryover hole.”) Business traders often use entities to pay salary to the owner in connection with a retirement plan contribution, which otherwise isn’t possible unless a trader has other sources of earned income or is a dealer member of a futures or options exchange.
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 still must achieve trader tax status.
Trading in an entity fixes most of these problems. The entity is divorced from your individual and IRA accounts for purposes of wash sales since the entity is a different taxpayer. (If you have a single-member LLC, you should file an S-Corp election so it’s not considered a disregarded entity.) You can break the chain on year-to-date wash sales in taxable individual accounts by switching over to an entity account mid-year or at year-end, and prevent further permanent wash-sale losses with IRAs. If the entity qualifies for trader tax status, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions).
With 2014 guidance from the IRS on self-employment income (SEI) and Obamacare Net Investment Income (NII) for traders, we pivoted our entity strategies to recommend S-Corps, or adding a C-Corp to a partnership, for the health insurance premium and retirement plan deductions.
Starting in 2014, we suggested business traders use entities in one of three ways:
S-Corporation tax return: Trading in an S-Corp tax structure means you don’t need a second entity. This is the best and most simple solution if there is no tax on S-Corps in your state. Have a base salary for covering the health insurance premium deduction, even if you have trading losses, although profits look better. If you have sufficient trading profits by Q4, establish a retirement plan before year-end. Start with the 100% deductible employer 401(k) elective deferral ($17,500 for 2014 and $18,000 for 2015) and pay it before year-end through payroll since it’s reported on the annual W-2.
If you have large trading gains, increase payroll in December for a performance-based bonus to unlock a 25% employer 401(k) profit-sharing retirement plan contribution that you don’t have to contribute into the plan until the due date of the tax return (including extensions). The maximum defined-contribution profit sharing plan amount is $52,000 plus $5,500 catch-up for 2014, and $53,000 plus $6,000 catch-up for 2015. (For details about retirement plan choices, limits and savings, see Chapter 8.)
If you use an S-Corp, read more below about S-Corp issues including officer’s reasonable compensation, stock and debt basis and accounting allocations.
Partnership tax return: Trade in a general partnership or multi-member LLC filing a partnership return. It’s difficult to achieve targeted SEI for health insurance and retirement plan AGI deductions. Perhaps you have retirement and health arranged in another business or job or through your spouse.
If you don’t need retirement and health insurance AGI deductions, the partnership tax structure alone works fine. In most states, a general partnership or LLC can elect S-Corp status at a later day, generally by March 15 of a current tax year. (Only six states don’t allow a general partnership to file an S-Corp election.) So consider an S-Corp election for 2015 by March 15, 2015 if you want to add retirement and health insurance deductions for 2015. Otherwise, if you miss the S-Corp election deadline you’ll have to wait another year, unless you add a management company to the mix well before year-end.
(For more, see New IRS Guidance on SE Tax Deductions Affects Partnership AGI Deductions.)
Add a management company as a second entity: Trade in a general partnership or multi-member LLC filing a partnership return and add a C-Corp or S-Corp as a second entity (a management company).
Why have two entities? In some jurisdictions like California and New York City, you can’t use an S-Corp trading business alone. California has a 1.5% franchise tax on S-Corps, so once you make over $53,000, you’ll owe tax over the $800 minimum tax. If you have large trading capital and expect trading income far higher, then consider the dual-entity structure.
New York City doesn’t grant S-Corp status and there’s an LLC publishing fee, so we recommend a general partnership trading company and a C-Corp management company.
Other traders prefer a C-Corp for a management company because they can add a medical reimbursement plan (not allowed in a pass-through entity for more than 2% owners). This also avoids some Obama-era taxes on individuals including the top rate of 39.6% and the net investment tax of 3.8%.
C-Corp tax rates are materially less than top individual rates. The C-Corp federal tax rates are 15% on the first $50,000 of C-Corp net income and they rise to 34%. If you live and work in a tax-free state, C-Corp double taxation is less of a concern.
Form an LLC or corporation and you can choose between C-Corp or S-Corp tax treatment within 75 days of inception (by filing a Form 2553 S-Corp election). We prefer LLCs.
The challenge with two entities is how to get the right amount of income into the management company to maximize employee-benefit plans, compensation and net income that you desire. C-Corps are tricky, as you want to guard against losses and excess income triggering the higher tax rates. S-Corp management companies don’t have either of these problems.
It’s hard to manage your net income in a trading business as performance fluctuates significantly. For this reason, the S-Corp trading entity as one entity is the best solution, providing the S-Corp is favorable in your state.
The management company should own a small percentage of the trading partnership to bring trader tax status to the partnership level. The management company can charge a reasonable administration fee, perhaps $1,000 or $2,000 per month at most. (Formalize administration fee agreements early on.) That’s not enough for maximizing compensation and employee-benefit plans.
The management company (S-Corp or C-Corp) can also get a profit-allocation (carried interest) in the partnership agreement (perhaps 1% to 30%), which can provide the additional income needed to maximize high-deductible retirement plan deductions. The profit allocation clause in the partnership agreement is better than a C-Corp owning a higher percentage of equity, as you don’t want partnership trading losses allocated to a C-Corp where there is no immediate tax relief to the owner. (Read the rest of the chapter and guide.)
This blog post is an excerpt from Green’s 2015 Trader Tax Guide, chapter 7 on entities.
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