Author: Barbara Weltman
Day Traders: Beyond Sole Proprietorship
With today’s technology and changes in SEC rules, many individuals now use their home computers to make money in the stock market through daily trading. Most traders jump into this activity because they believe they can make serious money; they don’t give thought to whether they should adopt a more formal business structure for their trading activity. If you are day trading or thinking about doing it, understand the special tax rules applicable to you and whether it makes sense to use a formal business entity for trading activities.
Who’s a day trader?
There are three unique tax statuses for those dealing with securities:
- Dealers: These are licensed securities brokers who buy and sell securities for others; their formal business entity and tax treatment doesn’t concern you.
- Investors: These are individuals who buy securities with the hope that they’ll realize income through dividends and long-term capital appreciation–the “buy-and-hold strategy.” Investors are by far the largest group of taxpayers engaged in securities transactions. Investors report their capital gains and losses on Schedule D of Form 1040 and claim any investment-related expenses as an itemized deduction on Schedule A (only miscellaneous expenses in excess of 2% of adjusted gross income is actually deductible).
- Traders: These are individuals who buy and sell securities for their own account and hope to realize income through short-term swings in the marketplace (rather than taking long-term positions)–usually executing positions within minutes, hours or a few days. There are no solid statistics on how many people engage in day trading, but is has been estimated that as many as two million individuals are currently doing it. As long as these activities are substantial and carried on with continuity and regularity, gains and losses on trades for stocks, bonds or exchange-traded options on individual company stocks are reported on Schedule D, but expenses are usually deducted on Schedule C.
Special mark-to-market election.
Those with trader status have serious risk of substantial loss; even skilled day traders can lose a lot of money in a short time. Usually, capital losses can only offset capital gains plus $3,000 of other income (e.g., interest income or salary from a job), with unused losses carried forward.
To be able to take full advantage of any and all trading losses, traders can elect to use the mark-to-market method of accounting. This means reporting income and losses on both realized and unrealized positions for the year. More specifically, in addition to actualized gains and losses, paper gains and losses are taken into account on the last day of the year as if the securities had been sold. Once this election is in place, trades are reported on Form 4797 instead of Schedule D. (The election must be made within set time limits and becomes irrevocable without IRS permission to make a change.)
For example, one doctor who did extensive day trading had a loss for the year of more than $1 million, but because he did not make this election on time, he could only use $3,000 of the loss each year to offset the income from his practice.
Note: Net income from trading activities is not viewed as self-employment income, so traders do not pay Social Security and Medicare taxes on trading revenue.
Situations for formalizing the business
Usually, it makes sense for day traders to operate as sole proprietors, at least initially. They are not concerned with personal liability exposure and can optimize their tax position quite well.
But some day traders should look beyond their sole proprietorship and consider incorporating or setting up a limited liability. Examples:
- To formalize relations between two or more owners. Sometimes, individuals pool their resources into one trading account. In this situation, becoming a limited liability company, for example, in this case enables the co-owners to spell out how they plan to share profits, losses, business expenses and trading responsibilities.
- To obtain tax shelter. Trading activities can be used for special tax purposes. For example, say an individual with no health coverage wants to put medical insurance on a fully tax-deductible basis. He/she can set up a corporation that provides health coverage and a medical reimbursement plan. The corporation deducts these costs and they are not taxable to the owner-employee.
- To establish trader status. As explained earlier, in order to make the mark-to-market election an individual must first prove his/her activities amount to trader status. Those who trade on the side while maintaining a full-time or part-time job might use incorporation/limited liability formation as evidence that the trading activities are continuous and regular (why go to the trouble and expense of formalizing the entity without the expectation of pursing trading activities on a continuous and substantial basis). A formal entity is no guarantee that the IRS will recognize trader status, but it certainly can be helpful.
- To include other activities with day trading. Currently, there are many businesses now offering day-trader newsletters, training and advice. These businesses have formed limited liability companies to obtain personal liability protection.
Corporation or LLC?
Say you decide to formalize the business for your trading activities. Which type of entity should you use? Your choices:
- Limited liability companies
- C corporations
- S corporations
Taxwise, an LLC is taxed like a partnership if there are two or more owners, or like a sole proprietorship if there is only one owner. This means income and expenses of the business are reported on the owner’s personal income tax return; in the case of partnership treatment, each LLC member reports his or her share of the business’ income, losses and credits on a personal return.
There are two types of corporations: Regular (called “C”) corporations and S corporations. A corporation is a separate legal entity set up under state law that fully protects the assets of its owner (shareholder) from the claims of creditors; both a C corporation and an S corporation provide the same personal liability protection for owners.
The distinction between the two types of corporations is how they and their owners are taxed. Incorporation automatically makes the business a C corporation, which is a separate taxpayer. The corporation reports its income and expenses on a separate tax return, Form 1120, U.S. Corporation Income Tax Return. C corporations can take capital losses only to the extent of capital gains; unused capital losses can be carried back for three years and forward for up to five years only. In this type of entity, the owner reports on his or her personal income tax return only compensation and other taxable amounts received from the corporation.
Owners of a corporation can opt, instead, to report the business income and expenses on their personal returns. (The corporation cannot have more than 100 shareholders, but should pose no problem for traders.) Obtaining S corporation status is done by electing it–the federal election is made by filing Form 2553, Election by a Small Business Corporation (there may be a separate state election required to achieve S status for state income tax purposes). There is no government fee for making the election. The election can be made as soon as the business is incorporated. Making the election means that, as in the case of the LLC, income, losses and other tax items pass through the corporation to the shareholder and are reported on the shareholder’s personal tax return (the corporation does not pay tax).
The S corporation files a return, Form 1120S, U.S. Income Tax Return for an S Corporation, which acts as an information return, telling the IRS about the business’s income and expenses. The owner reports the net amount on his or personal return.
Note: Even a one-owner S corporation must file their return.
Bottom line: There is no hard and fast rule in deciding which type of entity to use for day-trading activities. Continue as a sole proprietor if this suits your personal and tax needs. However, if you want to ramp up your activities or have special concerns, weigh the advantages and disadvantages to each entity choice.
This article was written for BizFilings by Barbara Weltman, a popular guest speaker on small business issues. She has lectured at national and regional conferences sponsored by prestigious forums such as SCORE, Barnes and Noble, The Learning Annex, and the U.S. Small Business Administration.