As trading becomes more accessible due to the proliferation of online and discount brokerage firms, more people are participating in the stock market. However, as an individual or sole proprietor, traders cannot take advantage of some of the tax advantages and asset protection strategies that are available to companies.

Working as an independent trader can be a way for individuals to make extra income, or even possibly a full-time living. But like any business venture, the income generated from trading is taxable. If you are successful as an independent day trader, it can create significant tax liabilities for you. Individuals who want to actively participate in the stock market have several options: they can trade as individuals or sole proprietors, qualify for trader status, or trade through a business entity such as an LLC.

For the active trader, creating a legal trading business will often provide the best tax treatment and asset protection.

Tax Treatment for Traders

According to the Internal Revenue Service (IRS), trading is not a business activity. In fact, all income from trading is considered unearned or passive income. This presumes—from the perspective of the IRS—that investors are individuals, and any trading activities are done for long-term capital accumulation, rather than paying for current liabilities. For this reason, unless an individual can qualify for trader status, they will be treated like any other tax-filing individual.

Income from trading can also not be reduced by contributing to an individual retirement account (IRA) or a pension fund. The only advantage of 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 what is normally afforded to W-2 wage earners (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 by the IRS, all the expenses necessary to trade are not eligible for tax deductions. For most active traders, the costs of necessities—such as education, a trading platform, software, internet access, and computers—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.

Potential Tax Remedies for Traders

To avoid this type of tax treatment, some active traders try to qualify for trader status. The requirements for achieving trader status are laid out in IRS Publication 550.

A qualified trader is allowed to file a Schedule C form and deduct business expenses, which could include education, entertainment, margin interest, and other trading-related expenses. Qualified traders can also take a Section 179 deduction for equipment used in trading activities. Finally, a qualified trader can elect a Section 475(f) election, also called the mark-to-market (MTM) election.

MTM accounting allows qualified 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. 

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; they can deduct all losses in the year they occur, providing the maximum tax relief in the current year. Some traders will also elect MTM 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.

How the IRS Defines a Qualified Trader

In IRS Publication 550 and Revenue Procedure 99-17 and 99-49, the IRS sets out general guidelines that explain the activities that qualify trading as a business. To be engaged in business as a trader in securities, a person must trade from their account on a full-time basis and derive most of their income through day trading. According to the IRS, a trader is someone who trades significantly and continuously to profit from short-term fluctuations in security prices. 

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 significant expenses to conduct their business. Although not specifically required, most qualified traders will open and close multiple trades daily and hold their positions for fewer 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. In reality, only a small percentage of individuals qualify for this IRS status.

Form a Separate Corporate Entity

If you cannot qualify for qualified trader status, another way to ensure you are receiving similar tax treatment is to create a separate corporate entity through which you will conduct your trading activities. By creating a limited liability company (LLC) or limited partnership, you can receive the same tax treatment as a qualified trader without having to qualify.

This type of legal entity usually receives less scrutiny from the IRS. It's unlikely that anyone would go through the trouble and expense of forming the entity unless they were committed to trading as a business venture.

It is very difficult for individuals to change an 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 Equals More Entities

For highly successful traders, some financial advisors may suggest forming a business structure that includes multiple entities, as a way of maximizing the tax and protection benefits afforded to the business. Even though the actual structure is determined by an individual's financial goals, this type of legal business structure 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, usually up to 30% of revenue, can be transferred to the corporate entity through a contracted management fee in order to take advantage of additional tax strategies.

For example, 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 educational expenses, while also building Social Security and Medicare accounts. Medical reimbursement plans can be created to fund all types of elective health care procedures and medical insurance premiums. Retirement accounts, such as individual retirement accounts (IRAs) and 401(k) plans, can be transferred into a 401a, a type of pension fund that allows annual contributions and can never be accessed 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.

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.

However, the amount of legal protection is determined by state law. Many advisors suggest forming the entity in the state of Nevada because of its lack of corporate income tax, the flexibility to change orders as a sole remedy by creditors, the anonymity of not having to identify shareholders, and the ability to nominate corporate officers.

The Bottom Line

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, it is in your best interest to speak with financial professionals who understand the formation and operation of these entities for traders.