Trading as a Business
“The elements of good trading are (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance.” – Ed Saykota
If you are a profitable trader, these few ideas can help you successfully mitigate some of your tax liability
Information that I present here is typically going to be useful for traders that have exhibited a long standing and sustainable profitability. For less experienced traders, the information should still be useful but likely impractical to implement.
I am not going to spend any time discussing how to become a profitable trader. There is a plethora of information on the Internet regarding trading setups, long/short biases, styles, chat rooms etc. A successful trader will exhibit two traits: patience & discipline.
I will discuss a variety of tools and/or platforms that help me run my trading activity within a business entity. See Tools & Reviews Tab.
Form a Business Entity
There are a few different business entities that an active and successful trader may elect. Even though, there is no single entity that fits all traders, I will focus on a Limited Liability Company (LLC) specifically. It is one of the simplest structures and it unlocks many significant tax breaks afforded to active traders.
A limited liability company is a business structure whereby the members of the company are not personally liable for the company’s debts or liabilities. Limited Liability companies are hybrid entities that combine the characteristics of a corporation and a partnership or sole proprietorship. While the limited liability feature is similar to that of a corporation, the availability of flow-through taxation to the members of an LLC is a feature of partnerships.
Top Tax Deductions for trading under an LLC umbrella:
- Data Feeds (i.e. Trade Ideas, Platform Fees, Level II)
- Data Logging Services (i.e. Tradervue)
- Margin interest / Locate Fees
- Computer Software & Hardware
- Chat or trading room subscriptions (i.e. Tradecaster)
- Trading books, publications, newsletters & newspapers
- Cell Phone, Internet service
- Webinars, Seminars (including transportation & lodging costs)
- Home office deduction or Rent (if leasing office space)
- Wages paid to family members
- Payroll Service Subscription (i.e. Gusto)
- Other Internet Services (i.e. PureVPN)
- Legal Fees / Incorporation Costs
- Tax & Accounting preparation & consultations
- An easier path to qualify for Trader Tax Status
Qualify for Trader Tax Status
What does it mean to achieve Trader Tax Status and why is it important? Via Section 475, it allows a trader to elect Mark-to-Market treatment. This automatically rids of Wash Sale rule and, most importantly, allows treating trading losses like an ordinary loss, and not a capital loss. What does that mean in practice? Without Trader Tax Status, a trader can only deduct $3,500 in capital losses a year. If you have a bad year and your losses from trading exceed $3,500, you can’t offset (deduct) it against other ordinary income. You’d have to carry it forward into future years. Trader Tax Status allows you to treat your trading P/L like ordinary income/loss, and not capital gain/loss.
How to Qualify (not a simple task but these steps will help)
- Form an LLC – show motive for trading. Log customary expenses to a trader (i.e. News Feeds, Data Level 2 Feeds, Chat/Educational Services, and Office Space)
- Purchase equipment used for trading such as computers and multiple monitor set-ups
- Must be able to prove 4 or more hours per day including research and administrative tasks
- Average holding period not to exceed 31 days
- Make 4+ trades a day. Buy and Sell count as 2
- Must trade on at lest 75% of available trading days
- Not mandatory but helpful: Account above $25,000
LLC (S-Corp) Election
A trader can further enhance the benefits of forming an entity by filing for an S-Corp election. This does not change the structure of your entity. The LLC still remains but you have elected to be treaded like an S-Corp for tax purposes.
What Are the Benefits?
- Pay yourself a reasonable salary. (i.e. Gusto). Avoid paying self-employment tax on the full spectrum of your gains.
- Pay a salary to your spouse or other family member. Deduct it as expense.
- Max out on funding your retirement plans. Up to $58k in 2021 via Profit Sharing Plans (i.e. Guideline). It is all tax deductible.
- Provide a healthcare plan to you and your family. A payroll provider like Gusto offers super easy setups and plans. It is all tax deductible.
- If you have employees, you may qualify for the 20% QBI deduction.