TRADERS: What is the best structure for tax savings?

Tuesday/August/19 22:27 Filed in: tax strategy | entity selection

For traders making several trades per month, the best way to structure your business for tax
benefits is to set up an entity structure.

ANALYSIS

:
You have three options:

Keep filing your Form 1040 (U.S. Individual Tax Return) year after year. That is the most expensive solution and unfortunately, that is what most people do.
Try to file as a "trader" and deduct your business expenses on Schedule C of your Form 1040. However, this is risky and does not offer any income tax strategies.
The best strategy that gives the most flexibility and the most beneficial tax strategy is a multiple entity structure.

The following is an explanation of the corporation - limited partnership strategy for active traders. This strategy can allow you to legally write-off your computers, home office equipment, all educational expenses, and a large percentage of meals, entertainment and travel.

When you file your Form 1040 tax return, the ability to deduct expenses related to your investment activities is extremely limited. Certain expenses are deductible, but these itemized deductions are subject to the 2% of adjusted gross income limitation. Additionally, deductions for investment seminars and home offices are categorically disallowed.

Another limitation is the Wash Sale rule. This rule prevents realizing losses on securities sales if you are in basically the same financial position in a 61-day window of time. The goal of the IRS is to prevent you from selling a position simply to record the loss, and then immediately buying back the stock at a lower basis price. Unfortunately, with active trading being more the norm, individuals often finds themselves moving in and out of the same stock within the same 61-day window.

One benefit of filing a Form 1040 tax return is the capital gain treatment of your long-term stock positions. If you hold your securities for 12 months or longer you can lower your capital gains tax bracket to as low as 10% or 20%.

In conclusion, if you work at a full-time job and are realizing capital gains in the stock market, you do not have any powerful methods for offsetting your tax liabilities. In fact, all of the expenses incurred in learning how to grow and manage your capital are almost entirely non- deductible.

Filing as a "Trader" on your Form 1040 tax return
The nature of this tax strategy is essentially this: You convert your investment activities into a trading business. Once your investing is recognized as a business, you are able to deduct any ordinary and necessary business expenses. However, the Internal Revenue Code is conspicuously quiet about how to qualify as a trading business. So, the burden has been placed on brave individuals who filed their 1040 tax returns and attempted to establish themselves as "traders" in order to write-off their business expenses.

Most of these individuals found negative rulings in the tax courts. The net effect is that it is nearly impossible to qualify as a trader. To qualify, you would most likely have to be trading full- time, hold your positions for less than a day, and trade a large amount almost every business day throughout the year. In essence, the court has said, "If you are not on the floor of the exchange, or holed up in a trading room, you do not qualify."

Some CPAs have been very active in promoting "trader status" filings. However, attempting to establish your trading business as an individual trader on your personal Form 1040 tax return is a risky proposition, considering a possible audit. The bottom line is that while a very small portion of active traders can realize substantial tax savings by filing as a "trader", a majority of investors do not qualify and need an alternative strategy.

Placing your trading capital in an entity structure
Instead of facing the risks of not qualifying as a "trader" on your personal return, there is an alternative method of qualifying that has several powerful tax benefits. Segregate your investment capital into long-term and short-term accounts The initial step is to divide portfolio assets into long-term holdings and short-term trading capital. Short term means positions held for less than one year. Another way to possibly describe this portion of funds is "risk capital". The long-term holdings will be kept in your brokerage account under your personal name.

Place your short-term account into a Family Limited Partnership
Next, you establish a family limited partnership (FLP). The IRS issues an employer identification number (EIN) for the FLP. The EIN is similar to your personal social security number. With your EIN, you can open up a brokerage account on behalf of the FLP. At the end of the year, the brokerage firm issues a Form 1099 to the FLP stating the proceeds generated in the account.

The FLP is a "pass-through" entity. This means there is no tax at the FLP; rather, the taxable income or loss flows through to the respective partners of the FLP level. For example, if you and another partner each owned 50% of the partnership, 50% of the partnership's taxable income (or loss) would flow directly onto your personal Form 1040 tax return and be subject to your ordinary income tax rate. In this simple scenario, the taxable income generated by the partnership would be lowered by the total ordinary and necessary business expenses incurred by the FLP during the course of the year. It would be a major plus if you could make $40,000 in short-term trading and offset that gain with $10,000 of deductible expenses.

However, the major drawback with this simple scenario of you individually owning an interest in a partnership is that it does not contain any provision for lowering your federal tax bracket. If you are already in the 39.6% tax bracket, you do not want your trading gains flowing to your personal return and then being subject to that high tax rate. The solution is to have a portion of the limited partnership owned by another entity that has its own tax bracket. This is called income splitting. You are taking the partnership's taxable income (or loss) and shifting them to another person or entity that is in a lower tax bracket. The other entity would be a Corporation.

Establish a corporation as the general partner of the FLP.
In a FLP there are two classes of partners, limited and general. The general partner is responsible for the management of the partnership. The general partner is the one executing the trades on behalf of the partnership. The general partner can either be an individual or a legal entity. In this strategy, you establish a corporation and that corporation acts as general partner. You can be the sole owner of the corporation, or you can issue stock in the corporation to a spouse, children, relatives, or whomever.

Let's say that the corporation owns 20% of the FLP. During the year, your partnership earns $100,000 in its trading account. You offset that gain with $10,000 in partnership business expenses. You are left with a $90,000 net partnership taxable income. As a result, $18,000 of the partnership's taxable income is allocated to the corporation, while $72,000 flows to your individual return. The corporation would be in the lowest corporate tax bracket of 15% and would pay $2,700 in taxes, and this is not even taking into account the numerous business expenses that a corporation can take. Had that $18,000 have gone to your individual return and been taxed at the highest bracket of 39.6%, the tax on that would have been $7,128, instead of $2,700, a saving of almost $4,500.

Advantages of using a corporation
One of the most exciting things about using a corporation is the sheer amount of tax deductions and perks that are available to corporate owners and company employees. Congress has created tax laws and special exemptions for corporations. It is the lobbyists of the major corporations that have paved the way for you. Now, you can own your own corporation and be able to write-off all "ordinary and necessary" business expenses, fully deduct the costs of attending board meetings that are held in vacation areas, write-off all medical expenses with no limitations, contribute up to $30,000 to your own pension plan and much more.

For individuals that are generating a large amount of excess revenue, the corporation structure allows you to start-up additional businesses with the expenses of the new business offsetting the income from the trading business. Another great benefit of the corporate entity is that it is a perpetual entity. Many individuals choose to retain the controlling interest in the corporation, and gift the non-controlling stock to their beneficiaries early in the growth of the business. That way, all future growth occurs in the estate of the beneficiaries, so that when you pass away, your beneficiaries do not need to sell off your business simply to pay the taxes. All they would be receiving is the small amount of controlling stock.

Conclusion
While certainly not complete in nature, this memorandum suggests several benefits of establishing a personal corporate entity. If you are a part-time trader, or even earn excess income from varying sources, you can create a situation where you can take advantage of major tax strategies usually reserved for individuals with full-time businesses by establishing a multiple entity structure.

Tags: investors, day traders, tax strategy