As an accountant who specializes in trader taxation, one of the more frequent questions I get from traders is whether or not to incorporate their trading business.
Some traders are unsure whether they would qualify for trader status unless they were incorporated. Other traders are afraid that being a sole proprietor trader might trigger an audit. There are even traders who believe that they will not be able to deduct business expenses unless they are incorporated. To add to this confusion, there are accounting firms who try to push an LLC (Limited Liability Corp) on every trader they come in contact with.
First of all, let’s dispel the myth that you need to incorporate in order to get classified as a business trader with the IRS. If you meet the requirements laid out in IRS Publication 550, you automatically qualify as a business trader, whether you are incorporated or not.
This qualification allows you to deduct your business expenses on a Schedule C on your Federal 1040. With some exceptions, you will get virtually all of the business deductions you would qualify for if you were incorporated. All traders start out trading as a sole proprietor (not incorporated).
For most traders just starting out, trading as a sole proprietor makes the most sense. It is simple and keeps your costs down as you build your trading business. You don’t have to worry about annual filings or annual meetings as a sole proprietor. You don’t have to file a separate corporate tax return each year. You also won’t have to worry about state franchise taxes (California has a minimum $800 tax).
WHEN DOES IT MAKE SENSE TO INCORPORATE YOUR TRADING BUSINESS?
There are several valid reasons to incorporate if you are a trader. The primary one, in my opinion, is to create earned income on your tax return. As a reminder, the IRS views trading gains as UNEARNED income. If you have no earned income, you will not be able to deduct healthcare expenses and/or contribute to a retirement plan. These deductions can mean thousands of dollars in tax savings. In order to create earned income, you’ll need to incorporate your trading business and pay yourself a salary.
LET’S LOOK AT AN EXAMPLE
Trader Jane is a profitable 55 year old trader looking for additional ways to save in taxes. She incorporates her trading business and pays herself $25,000 annually. She sets up a solo 401k plan and is able to contribute $23,000 ($17,500 plus the $5,500 catch up provision). Her trading business deducts the $25,000 salary from her trading gains. Jane deducts the $23,000 401k contribution from the salary, resulting in almost $6000 in tax savings!
Traders will also miss out on healthcare deductions if they do not have earned income from their trading business. If there is no earned income, all healthcare expenses are deducted on Schedule A of the Federal 1040, where it is subject to a 10% floor. For example, Trader John has $12,000 in health insurance premiums for the year and a $100,000 trading profit. Since he had no earned income, Trader John has to deduct his healthcare premiums on Schedule A, subject to the 10% floor. 10% of $100,000 equals $10,000 (the floor). Trader John is able to deduct $2,000 from his taxes ($12,000 minus the floor of $10,000) missing out on $10,000 in deductions and over $2,500 in tax savings!
Without earned income, these tax savings are not possible due to how the IRS classifies trading income. Profitable traders looking for more tax savings should consider incorporating their trading businesses to create this earned income.
SHOULD YOU INCORPORATE YOUR TRADING BUSINESS?
It depends on your circumstances. If you are a profitable trader, it may be the right thing to do. If you are just starting out, it might be something you just don’t need at this stage of your trading career. My best advice is to consult a competent trader tax expert and discuss your personal situation. They should explain the pros and cons of incorporating and help you decide whether or not it makes sense for your trading business.
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