Jim Forrester, CPA
The limited liability company, or LLC, is often referred to as a hybrid legal entity because it attempts to combine the advantages and minimize the disadvantages of the sole proprietorship/partnership on the one hand and the corporation on the other.
Although LLCs have been popular throughout Europe and South America for more than a century, they have only been in widespread use in America since 1977. As the new legal entity in town, they have quickly caught on as the preferred structure for traders who want to have their deductions and protect their assets, too.
The “Flow-Through” Entity
While you can trade as a sole proprietor, we don’t recommend it for several reasons: your trader status remains vulnerable to tax court findings, you have a much higher audit risk, you have no liability protection because your personal assets are not separated from your business assets, and your potential for tax savings is minimal.
Nor is a C or S corporation the answer for every trader: corporate record keeping, reporting and tax preparation can be cumbersome and time-consuming.
That’s why many traders choose the limited liability company. Like the limited partnership, an LLC is a “flow-through” entity; that is, your tax liability flows through the entity to you, the taxpayer. As a result, the profits or losses from the LLC are reported on the individual tax returns of each owner (known as “members”), instead of being taxed like a corporation at a separate business level.
Although most states allow an LLC to be formed by a single member, the IRS considers these “disregarded entities” for tax purposes. The IRS only recognizes LLCs formed by two or more members; these can be husband and wife, parent and child, friends, relatives, estates, trusts, corporations or other LLCs.
Advantages of the LLC
We will make the assumption that you will run your business with an honest “expectation of profit” and that your expenses are ordinary and necessary and reasonable and directly related to your business,” and that you properly document your deductions.
The LLC holds several advantages for traders:
Stability: The LLC is recognized by the IRS as a formal business entity and treated accordingly. The tax rules for LLCs are well defined, unlike those for sole proprietors that tend to change capriciously based on tax court rulings.
Reduced risk: As its name implies, the limited liability company protects your assets by limiting your liability to the amount you have invested in the business. Your personal assets as a member remain separate and apart from the LLC.
Full deductibility: If you elect the mark-to-market accounting method, your losses and business-related expenses are fully deductible against ordinary income, a feature that proves especially helpful to new businesses. The LLC enables you to convert what were previously personal or hobby expenses into deductible business expenses without fear that a sudden loss of trader status will whisk them away.
Retirement plan: Unlike a sole proprietorship, an LLC can generate “earned income” as defined by the IRS; therefore its members may set up a retirement plan that is deductible to the business and non-taxable for the members. A trader in an LLC, however, is not subject to the payroll taxes of earned income unless they want to receive some of their income as payroll. A sole proprietor’s trading income is not considered “earned income,” and therefore not eligible for tax-advantaged retirement plans.
“Retroactive” mark-to-market election: Unlike a sole proprietor, who must elect mark-to-market by April 15 of the year prior to beginning MTM, members of an LLC have two months from opening to note the MTM election in their minutes. If you miss the April 15 deadline, forming an LLC will enable you to “retroactively” elect mark-to-market.
Mark-to-market flexibility: Once a sole proprietor selects mark-to-market accounting, they are stuck with it. Members of an LLC, however, can end the designation simply by discontinuing use of the entity or dissolving the company and forming a new one.
Disadvantages of an LLC
Although an LLC has no direct disadvantages for a trader, there are potential adverse consequences for members in special circumstances:
Personal debt liability: In drafting their LLC statutes, some but not all states have followed a limited partnership tradition that prevents foreclosure of a member’s interest and forced liquidation of the LLC to satisfy a personal debt. In states that have not included this provision, a member’s creditor may be able to force foreclosure and liquidation of the LLC to satisfy a member’s debt.
Ownership agreement: Failure to properly draft and maintain an operating agreement could jeopardize the entity’s tax status. You could go to your state and order articles for your LLC, but if you do not have a proper operating agreement, and the necessary start-up resolutions and minutes, the chances are very good that during an audit your LLC will be disallowed and you will lose all of your business deductions
Minors: While minors may be members of an LLC, particular care should be taken in entities where fewer than two members are of legal age.
Trader tax status: An LLC alone will not protect your trader tax status if you fail to meet the IRS standards.
Limited liability companies can indeed provide the best of both worlds for many traders, combining the tax advantages of a sole proprietor/partnership with the asset protection and secure tax status of a corporation. But every trader’s needs are different. At Traders Accounting, we can help you determine which legal entity will best enable you to reach your financial goals.
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