By Jim Forrester, CPA
The Internal Revenue Service has two tax codes: one for businesses, the other for individuals. Because businesses grow money both by paying taxes and employing other taxpayers, they are rewarded and encouraged through a benevolent tax code. Individuals, however, are treated far more harshly by routine tax hikes and diminishing deductions.
As a trader, your livelihood could hinge upon your ability to prove to the IRS that your trading enterprise is a legitimate business. Fail that and you risk a domino effect whereby your trader tax status is denied, your mark-to-market accounting method is disallowed, and your ordinary losses suddenly loom catastrophic thanks to the $3,000 capital loss limit.
Yes, you can legally conduct your trading business as a sole proprietorship. But with so many cards stacked against you not the least being the IRS’ vague and ever-changing definition of what constitutes a trader for tax purposes the far more prudent course is to conduct your trading through a more formal legal entity.
The rewards and reassurance of trading through a business entity so outweigh the risks and uncertainty of a sole proprietorship that the question is not why should you form a legal entity, but why wouldn’t you?
What Are Legal Entities?
There are five primary legal entity structures: sole proprietorship, limited partnership, limited liability company (LLC), S corporation and C corporation. Entities must be registered within the state where business is conducted. If you pay payroll to fund retirement accounts or medical insurance, your entity must be registered in your home state; in rare cases, however, some traders may wish to register their entity in a state that does not tax entity income. States and municipalities typically require legal entities to file documents, place advertisements and pay a fee to establish their legal formation.
For tax purposes, a legal entity is an organization recognized by the IRS by its corresponding Employer Identification Number, whether it has employees or not. Sole proprietors often use their Social Security number as their Employer Identification Number.
Sole Proprietorships: Risky Business
Trading as a sole proprietor is a little like walking a tightrope without a net: one misstep and it’s a long, fast fall.
What makes a sole proprietorship so risky for traders is the precarious nature of trader tax status. Because neither Congress nor the IRS has clearly defined what constitutes a trader, the guidelines continue to evolve through tax court case law. As a result, the trader status you enjoyed last year may not protect you and your business this year. The guidelines are largely based on cases involving individual taxpayers (sole proprietors), which the IRS typically view with far more suspicion than more formal business entities.
Sole proprietors also are more exposed than legal entities to personal financial risk. Because your personal and business assets are not separated, a business misstep could cost you your house, your vehicle and other personal assets.
Sole proprietors also are at a disadvantage come tax time. Because trading income is not considered self-employment income, you are not allowed to make tax-advantaged retirement contributions with it. Tax deductions are extremely limited for sole proprietors as well. Sole proprietors who do not select mark-to-market accounting are put in an odd position of reporting income on Schedule D as capital gain, but expenses on Schedule C as ordinary income, a discrepancy that can draw unwanted attention from the IRS.
Legal Entities Savor the Tax Savings
The chief reason to form a legal entity is to stabilize your business activities and expense deductions. Without a business entity to call home, your trader tax status could turn on the ruling of the next tax court judge. The tax status of legal entities however is well defined by the IRS; no more worrying whether you are suddenly going to face a different and unfavorable tax status.
By forming a legal entity and choosing the mark-to-market accounting method, your business deductions can range from $10,000-$20,000 annually. [Of course, that is just an average amount, and many of our tax clients have business expenses either lower or greater than that amount] Should you experience substantial losses, you’ll be able to fully deduct those as ordinary losses as well, thanks to the $3,000 capital gains waiver.
Legal Entity vs. Sole Proprietorship
How much can you save by trading as a legal entity? The short answer is plenty. Here is a hypothetical case that illustrates the financial advantages of a legal entity (“Business”) that has elected mark-to-market accounting verses a sole proprietor (“Investor”) who has not:
Let’s say you have $100,000 in income, $24,230 in expenses and a 30% tax bracket. On a $40,000 gain, as an investor you would qualify for $1,152 in tax savings, while as a business you would reap more than six times that $7,269 in tax savings. On a $40,000 loss, as an investor you would realize $3,700 in tax deductions, while as a business you would deduct the full amount of your loss, a whopping $64,230.
The bottom line: Whether you have a gain or a loss, trading as a business entity has clear advantages over the uncertainty and possible loss of trader tax status at stake for sole proprietors.
Which Entity to Choose?
While the benefits of trading as a legal entity are numerous, there is no one legal entity or structure that is right for everyone. A Traders Accounting ‘Tax Action Plan’ can help you determine if a limited liability company, a C corporation, or a combination of the two will most benefit your trading business.
For more information, visit TradersAccounting.com