Everyone’s a trader these days – doctors, lawyers, students – anyone who realizes the importance of managing and growing the money that they earn. A lot of people look at it as a great way to supplement their income stream or even replace it in the future. Paying lower taxes clearly increases your net income and contributes to your success as a trader. Yet there is such little information about the tax issues that apply to traders.
One thing you may not know is that, just like with any other job, correct planning is vital to reducing your tax burden as a trader. Repeat after me: there are great tax breaks for traders who know how to use them. That said, you will need some advice from your accountant but after reading this article, you’ll know what to ask them and what you need to be on the lookout for.
Traders are eligible for “trader tax status” and the “trading rule” for business tax breaks, including mark-to-market accounting. You and your investors can also reap the benefits of creating a trading entity with a lower fee structure. Let me explain.
Trader Tax Status and the Trading Rule
If you are trading seriously, you can start a trading company – a sole proprietorship, a partnership or any other formal structure. You may also have outside investors – friends, clients, family, self-owned entities – and benefit from the creation of a formal company.
Traders actively managing family or other trading entities, etc. can use the trader tax status and the trading rule for business tax breaks in order to pass the advantage on to their investors. Typically, individual investors will be subject to IRS rules that treat the income or loss as an investment. This means that while you get one single tax break on long term capital gains with a favorably low rate, you give up a lot of your benefits on the side of losses and expenses. On top of that, if you are in the red, the long term capital loss limit is a paltry $3,000 and other limitations on expenses are even worse. Here are some illustrative examples of the tax disadvantages of not obtaining trader tax status:
- Tommy has a short-term capital gain of $4,000 and a long-term capital gain of $6,000. The short-term capital gain is taxed at Tommy’s ordinary tax rate; the long-term capital gain will be taxed at a favorable tax rate of 15%.
- Tina has $8,000 short-term capital gain and a $6,000 long-term capital loss. The long-term capital gain and long-term capital loss will be netted to create a $2,000 gain that is viewed as short-term in nature because it takes the characteristics of the number that is larger. This short-term capital gain is taxed at Tina’s ordinary tax rate and not at a favorable 15% tax rate.
- Mike has a long-term capital loss of $8,000 and short-term capital loss of $4,000. Both the losses will be netted together to create a $12,000 loss. Mike will only be allowed to take a $3,000 loss deduction for the current tax year (must be taken out from the short-term loss first) and the remaining losses will be carried forward indefinitely and included on future tax returns.
Trading Rule for Businesses
As a qualifying active trader, you and your investors can benefit from the business treatment of income and losses by setting up a trading company. This will allow you to deduct all types of losses and expenses associated with your trading business against all other taxable income on your tax return, enabling you to pass on this advantage to your investor as well. Hence, even if you have no taxable income, your trading business expenses can translate to a Net Operating Loss that can be carried back or forward to generate larger tax refunds.
Note: The IRS has grouped investment and passive activity separately. Passive activity refers to trade or business in which you have not materially participated during the year and is often associated with limited liability entities. Real estate rentals and limited partnerships are examples of passive activities. Usually, an investor in a regular company (non-trading setting) that receives business treatment would be subject to the unfortunate passive activity rules. This would force investors to suspend net passive losses into the future to reduce future passive gains.
Here is an illustrative example of this:
- In the current tax year, Gary has a salary of $50,000. Gary also has income from three passive activities totaling $33,000 and losses from two other passive losses totaling $40,000. Income and losses from all passive activities are netted together. Although a net passive loss exists, no loss can be deducted in the current year. Gary would not be able to reduce his taxable income in the current year due to these passive activities grouping by the IRS.
However, the trading rule loophole provides investors in trading entities to circumvent the unfavorable passive activity rules by allowing them to treat income, expenses and losses from trading as a regular business would (excepting interest income).
All in all, a good strategy would be for a trading company with a business status to separate its long term investments in order to generate greater capital gains. That being said, you can invest in long term investments such as bonds and preferred stocks using your regular status as an individual while investing in short term investments with your trading entity status. This way you get the best of both types of treatment, i.e. a favorable tax rate for capital gains while deducting your business expenses on Schedule C (Business Profit or Loss).
How do you Qualify for Trader Tax Status?
Before you get excited about your trader tax status, you must qualify for it in the eyes of the IRS. It will allow you to report trading and business expenses on your individual tax return as well as retrospectively for up to three years. The rules are subjective and vague so it’s really up to the IRS’ assessment of your individual case.
The tax court law states that:
- The trading must be substantial, frequent, regular, continuous (as opposed to periodic), and that
- The trader attempts to profit from daily changes in the market by adopting short term positions rather than long term investments.
Clearly, this is easy if you have no other sources of income and you trade all day, everyday. If you are a part-time trader with another job, you may still qualify if you can show that you spend three hours a day or more on your trading company. Another way is to qualify as a pattern day trader, meaning that you transact four day trades in every five days.
The second opportunity that you have for a tax break is to elect mark-to-market accounting. What this means is that at year-end, all positions will be calculated at the current market value, thus the realized value of all unrealized gains and losses is put on your balance sheet. This converts your capital gains and losses to ordinary gains and losses.
While short term gains see no benefit from this election, ordinary losses can be used to offset any income in your tax return filing. You can carry back or forward net operating losses and receive refunds on prior income tax returns or deduct it from future filings. As a trading entity, all you need to do is file an election to use the mark-to-market accounting by April 15 of the current year.
Trading Entity Selection
Selecting the appropriate business entity type will also be crucial to the tax treatment of your trading business. There are various options – sole proprietorship, partnership (also a husband-wife partnership), SMLLC, LLC, S-Corporations, etc. The NASDAQ will designate your entity account as professional or non-professional depending on your entity type. Professional fees are obviously higher than non-professional fees.
So, while you need to create an entity for tax purposes, you may find yourself paying higher fees. Your broker may be able to help you by putting your individual, personal name on the data feed agreement with NASDAQ. This can be done via the husband-wife partnership or in some cases, the sole proprietorship. An SMLLC may also be eligible for non-professional fees if your broker can show that you fully own the entity.
A word of caution here – you are ultimately responsible for any representations made on your subscription agreement with the NASDAQ. So be aware and fully understand the actions of your broker on your behalf.
Most tax breaks for traders are on the loss or expense side, but the value of this should not be underestimated. It can allow you to reduce your tax liability by making expenses and losses tax-deductible and reducing the amount of income you pay tax on. This means an increase in your real income – which is what it’s all really about at the end of the day.