With the proliferation of online and discount brokerage, people are trading the stock market in ever increasing numbers. However, as an individual or sole proprietor, traders cannot take advantage of the myriad of tax advantages and asset protection strategies available to companies. Trading the market can be a gainful way to make extra income, or even possibly a full-time living. Like any business, the income generated from trading is taxable and can create significant tax liabilities for the successful trader. (For more on this, read our Brokers and Online Trading Tutorial.)

In deciding on what structure to trade through, individuals can trade as individuals or sole proprietors, qualify for trader status, or trade through a business entity. For the active trader, creating a legal trading business will often provide the best tax treatment and asset protection.

Tax Issues
According to the IRS, "trading" is not a business activity. In fact, all income from trading is considered unearned, or passive, income. The presumption is that individuals are investors and that any trading activities are done for long-term capital accumulation and not for paying current liabilities. For this reason, unless an individual can qualify for trader status, he or she will be treated as any other tax filing individual. (For seven guidelines to help you keep more of your money in your pocket, read Tax Tips For The Individual Investor.)

Income from trading cannot be reduced by contributing to an IRA or pension. The only advantage to being considered a passive trader is that the income derived from trading is not subject to additional self-employment taxes. After that, deductions are the same as normally afforded to W-2 wage earners, which are generally limited to mortgage interest, property taxes and charitable deductions. The amounts of most deductions are restricted to a percentage of adjusted gross income. Because trading is not considered a business activity, all the expenses necessary to trade are excluded as deductions. For most active traders, the costs of necessities such as education, a trading platform, software, internet access, computers and the like can be considerable.

For most traders, the biggest tax issue they face is that deductions for trading losses are limited to gains. After that, only $3,000 can be deducted against ordinary income. In a year where net capital losses exceed $3,000, individuals can only carry forward $3,000 of that loss per year against future income.

Tax Remedies
In order to avoid such tax treatment, some active traders try to qualify for trader status. The qualified trader is allowed to file a Schedule C and deduct ordinary and necessary business expenses, which would include education, entertainment, margin interest and other trading-related expenses. Qualified traders can also take a Section 179 deduction and write off of up to $19,000 a year for equipment used in trading activities. Finally, a qualified trader can elect a Section 475(f) or the mark to market (MTM) election

Since the late 1990s, mark-to-market accounting has allowed traders to change their capital gains and losses to ordinary income and losses. On the last day of the year, all positions are assumed to be sold at market value and a hypothetical gain or loss is calculated. For the following year, the basis for each of these positions is calculated by assuming they were also purchased at market value. The hypothetical gains and losses at year end are added to actual gains and losses for tax purposes. (Mark-to-market accounting can be a valuable practice, but all bets are off when the market fluctuates wildly. Read Mark-To-Market: Tool Or Trouble? and Mark-To-Market Mayhem.)

Because gains and losses are regarded as ordinary income under MTM, all losses are deducted in the year they occur. Under MTM, traders are not bound by the $3,000 net capital loss limitation and can deduct all losses in the year they occur, providing the maximum tax relief in the current year. Some traders will also elect MTM in order to avoid the 30-day wash sale rule, which disqualifies loss deductions on "substantially identical" securities bought within 30 days before or after a sale. (For related reading, see Selling Losing Securities For A Tax Advantage.)

How the IRS Defines a Trader
In IRS Publication 550 and Revenue Procedure 99-17, the IRS has set out general guidelines that provide guidance as to the activities that qualify trading as a business. To be engaged in a business as a trader in securities, a person must trade on a full-time basis, and derive most of his or her income through day trading. According to the IRS, a trader is someone who trades significantly and continuously in order to profit from the short-term fluctuations in security prices. (For more on this type of career, see Quit Your Job To Trade Stocks?)

Traders are individuals who make multiple trades daily to profit from intraday market swings and do so continuously throughout the year. They spend a considerable amount of time documenting and researching trades and strategies and incur a significant amount of expenses in order to conduct their business activities. Although not specifically required, most qualified traders will open and close multiple trades daily and hold their positions for less than 30 days.

For active traders, the benefits of qualifying are obvious, but these guidelines are open to interpretation by the IRS and the courts. Only a small percentage qualify, even some whose only income is derived through trading. (For more, see Tax Effects On Capital Gains.)

A Legal Trading Business
The only way to ensure that you are receiving the same tax treatment as a qualified trader is to create a separate corporate entity to trade through. By creating a limited liability company or a limited partnership, you can receive all the same tax treatment as a qualified trader without having to qualify. The legal entity usually receives less scrutiny by the IRS because the assumption is that no one would go through the trouble and expense of forming the entity, unless they were committed to trading as a business venture. It is extremely difficult for individuals to change election such as MTM once it has been chosen. With the company, if there is an advantage to changing accounting methods or the legal structure, the entity can simply be dissolved and re-formed accordingly.

More Success = More Entities
For highly successful traders, some advisors will suggest structures that include multiple entities to maximize the tax and protection benefits. Even though the actual structure is determined by an individual's financial goals, it usually includes a C corporation, which exists to be the general partner or managing member of several limited liability companies. In this way, extra income can be transferred to the corporate entity (usually up to 30% of revenue) through a contracted management fee to take advantage of the myriad of additional tax strategies available.

For example, in order to fund college expenses or to give children money tax free, family members can become employees. The corporation can then take advantage of deductible salaries and education expenses, while building Social Security and Medicare accounts. Medical reimbursement plans can be created to fund all types of elective healthcare and medical insurance premiums. Retirement accounts such as IRAs and 401(k)s can be transferred into a 401a, an ERISA pension fund that allows contributions of up to $49,000 per year and can never be attacked by creditors or through a legal claim. Because the corporation pays taxes on net income, the goal is to pay as many expenses as possible with pretax dollars and to minimize taxable income. (Find out how becoming a corporation can protect and further your finances in Should You Incorporate Your Business?)

This type of business structure also provides excellent asset protection because it separates the business from the individual. Long-term assets can be held by other limited liability companies that can use accounting methods better suited for investments. All assets are protected from creditors and the legal liabilities of the individual because they are held by separate legal entities. The amount of legal protection is determined by state law. Many advisors suggest forming these entities in states that will not allow the piercing of the legal structure. Most prefer Nevada because of its lack of corporate sales tax, flexibility to charge orders as sole remedy by creditors, the anonymity of not having to list shareholders, and the nomination of corporate officers. (Could incorporating your business help protect it? Find out in Asset Protection For The Business Owner.)

Although trading through a complex legal structure has obvious benefits, it also can add a significant amount of complexity to one's personal affairs. For traders who have been consistently profitable but cannot or do not want to qualify for trader status, trading through a simple business is essential. If you wish to set up a pension fund to defer taxes, pay salaries to loved ones or recoup significant medical expenses tax free, then the added complexity is a decent trade-off to gain the benefits of a compound structure. Either way, to receive the best tax treatment and legal protection, one should speak with advisors who understand the formation and operation of these entities for traders. (For related readings, see Build A Wall Around Your Assets.)

Related Articles
  1. Investing News

    6 Signs You Are Addicted To Investing

    An addiction to trading can ruin your life and relationships. Not to mention the monetary costs. There are telltale signs that you've gone too far.
  2. Trading Strategies

    How to Day Trade Sector ETFs Every Day

    Sector ETFs provide a liquid asset that day traders can trade each and every day. Here's how to find which sector ETFs to day trade and what to watch for.
  3. Trading Strategies

    Picking The Right Algorithmic Trading Software

    Willing to enter the tech-savvy world of algorithmic trading? Here are some tips to picking the right software.
  4. Trading Strategies

    Marijuana Penny Stocks: Where Risk Meets Sin

    Marijuana producers and users, working in a market that's still illegal in many states, are a risky but promising bet for investors.
  5. Investing

    Redefining the Stop-Loss

    Using Stop-losses for trading doesn’t mean ‘losing money’, but instead think about the money you'll start saving once you learn how they work.
  6. Trading Strategies

    Stock Trading for Free: Now a Reality

    Believe it or not, you can now trade stocks and ETFs for free. Here's a look at providers offering commission-free trading.
  7. Trading Strategies

    The Top Spread-Betting Strategies

    What are the most commonly followed spread-betting strategies (in countries where it's legal)?
  8. Trading Strategies

    Who Actually Trades or Invests In Penny Stocks?

    Although penny stocks are highly speculative, millions of people trade them daily. Here are 10 different types who do.
  9. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  10. Investing Basics

    5 Things to "Deliberately" Do to Improve Your Trading

    Most traders are putting in trading hours, but not improving. Here are deliberate steps that can take your trading to the next level.
  1. What is a family Limited Liability Company (LLC)?

    A family limited liability company (LLC) is formed by family members to conduct business in a state that permits such form ... Read Full Answer >>
  2. What risks does a business owner face under a business structure with unlimited liability?

    The risks that a business owner faces under a business structure with unlimited liability are literally unlimited, but they ... Read Full Answer >>
  3. What's the difference between a financial plan and a financial forecast?

    Selecting the appropriate business structure for a new company can present challenges to an entrepreneur. Considerations ... Read Full Answer >>
  4. How can I merge technical analysis and fundamental analysis with quantitative analysis ...

    It is important for a sole proprietor with no employees to register as a limited liability company because an LLC provides ... Read Full Answer >>
  5. Which factors drive the marginal propensity to consume?

    A limited liability company (LLC) is not a separate entity from its business owners but is instead considered a pass-through ... Read Full Answer >>
  6. Do companies have to pay back their paid-up capital?

    One of the most important selections a business owner must make is determining which legal business structure is the most ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!