How To Structure A Trading Business For Significant Tax Savings?

 If you actively trade securities, futures, forex or crypto, consider setting up a trading business to maximize tax benefits. With a sole proprietorship, a trader eligible for trader tax status (TTS) can deduct business and home-office expenses and make a timely Section 475 election on securities for tax loss insurance and a potential qualified business income (QBI) deduction. By forming an LLC taxed as an S-Corp, a TTS trader can also deduct health insurance premiums and a retirement plan contribution. An investor without TTS cannot get any of these tax benefits.

The new tax law (TCJA) severely limits itemized deductions for investors, while expanding the standard deduction and improving business expensing. TCJA also introduced a 20% deduction on QBI, which includes a TTS trading business with Section 475 income but excludes capital gains and portfolio income. With TCJA, TTS and Section 475 are more valuable than ever before.

Sole proprietorship

An individual TTS trader deducts business expenses and home office deductions on a Schedule C (Profit or Loss From Business – Sole Proprietorship), which is part of a Form 1040 filing. Schedule C losses are an above-the-line deduction from gross income.

It’s easy to set up a sole proprietorship. First, open an individual brokerage account(s) in the trader’s name and social security number. You don’t need a separate employer identification number (EIN) unless you plan to have employees on the payroll. You can also use a joint individual account but list the trader’s name and social security number first. There is no state filing required for a sole proprietorship as there is for organizing an LLC or incorporating a corporation. You also don’t need a “doing business as” (DBA) name, although you can obtain one if you prefer. There isn’t a federal or state tax election for claiming TTS — it’s determined based on facts and circumstances assessed at year-end.

Section 475 tax benefits

TTS traders are entitled to make a Section 475 election, but investors are excluded from it. I call it “tax loss insurance” because the election exempts securities trades from onerous wash-sale loss adjustments, which can defer tax losses to the subsequent year, and the $3,000 capital loss limitation. Ordinary loss treatment is far better; it can generate tax refunds faster than capital loss carryovers.

A partnership or S-Corp formed during the tax year is considered a “new taxpayer,” which can elect Section 475 internally within 75 days of inception. An individual TTS trader had to choose Section 475 with the IRS by April 15, 2019, so a new partnership or S-Corp comes in handy after the April 15 deadline. An existing taxpayer must also file a Form 3115 (Application for Change in Accounting Method), whereas a new taxpayer adopts 475 from inception, so this filing isn’t necessary.

Partnerships

A trader can organize a spousal LLC and file as a partnership. Alternatively, the trader can form a marital general partnership without liability protection afforded by an LLC. Partnerships file a Form 1065 partnership tax return. Establishing a separate legal entity does not alone generate tax benefits; it’s critical for the organization to qualify for TTS. Otherwise, the company is considered an investment company with suspended investment fees and expenses. An investment partnership cannot have business expenses, officer compensation, and employee benefits, including health insurance and retirement plans.

A TTS trading partnership may deduct business expenses, which the partnership Schedule K-1 reports in line one (“ordinary business income/loss”). The individual owner deducts business expenses. If the partnership agreement provides for it, the partner can also deduct “unreimbursed partnership expenses” (UPE) including home office expenses, on Schedule E page 2 (Supplemental Income and Loss). The amounts are entered on the “non-passive income” column since a TTS loss is exempt from Section 469 passive activity loss rules under the “trading rule” exception.