The Benefits of Forming a Corporation or LLC for Day Trading

The real question is why do I need a business entity such as a corporation or LLC? I just want to trade, make lots of money, go on vacation far away and live happy ever after…

We all have dreams and ambitions; it’s part of the American way of life. You may have chosen day trading for the flexible hours, self-direction, and/or financial independence. Like the rest of us, your dream is to become a successful day trader. The pursuit of any worthwhile dream does not come easy and by no means is there such a thing as “easy money”.

But what if becoming closer to your dream was as simple as making a lane change? Or, more specifically, changing the way you think about and transact your day-to-day trading activities?

Being in the business of specialized accounting for traders, we see all types of strategies used - in every financial sector and market. The amount of trading capital, frequency of transactions, and sector varies from one client to the next. Surprisingly, these factors are not what separates our consistently successful clients from the rest. We’ve discovered the most common attribute that cultivates trading success is those who treat their activity as a business.

By changing the way you treat the activity, you reinforce the two most important elements of any profitable business endeavor: 1) maintaining psychological discipline over the activity, and 2) managing and monitoring your cash flow.

Gaining Control of Emotions

Economists are divided between two theories of economics: rational economics and, the more widely followed, behavioral economics. The 2008 market crash was a clear indicator behavioral economics influenced the dramatic change in global markets. Most financial decisions leading to the crash were not based on solid data and complicated formulas, but based on human behaviors influenced by emotions.

Psychologist Brian Knutson at Stanford University conducted research on how the human brain produces emotions. The part of the brain called the "nucleus accumbens" is triggered by primal human needs and desires such as food, sex, and drugs. Mr. Knutson discovered when a person receives money, these very same circuits are activated in a very powerful way. In short, the same emotional behavior that is stimulated by illicit drug use, sex or even a gambler’s anticipation for the next big payout, is the same as making money trading. Unfortunately, when a person loses money, the psychological impact is worse than the money loss itself. Some studies suggest that emotions from financial loss are the same emotions stimulated by a fear of personal safety or death.

Despite our psychological makeup, we can control emotions so they don’t adversely affect the financial decisions we make. Trading as a business helps condition you to remove the personal emotions by interpreting the activity as any normal day-to-day business. What’s more, maintaining the businesses bookkeeping and records, as required by IRS and state law, enables you to gain better control over losing trades. Only when psychological discipline is part of your business plan will you maintain consistent trading success.

Gaining Control of Cash Flow

We all know it is much easier to trade with more money than less. Effective cash flow management is simply generating more income than expense. Establishing the correct legal structure or entity for your trading business may reduce your largest expense, your tax bill. In particular, a Corporation, Limited Liability Company or other structure could help you reach the beneficial “Trader Status” and allow you to take deductions you may not otherwise be entitled to take as an individual.

Available Structures for Trading as a Business

A business entity is a structure built from state law where the assets and activities are separate from owners and operators. Certain types of entities can reduce personal liability and provide asset protection only when established and maintained properly. Please note: Following a state’s minimum filing and paperwork requirements will not guarantee any protection.

Here is a listing of available structures for trading as a business. Remember to ask one of our professionals about our free “Trader Tax Plan” service before choosing a trading structure.

Sole-Proprietorship: A sole-proprietorship requires no formation documents or state approval. This structure, although available, is typically not recommended due to higher chances of an IRS audit and no legal protection. Most tax court cases where a trader is disallowed “Trader Status” and/or Mark to Market Accounting originated from sole-proprietorship filings.

“S” Corporation: A subchapter “S” corporation is available to traders, but is typically not recommended. Using this structure will force the requirement of paying employment tax when other entities do not. Employment tax is an additional 15.3% tax on top of all federal and state tax requirements.

“C” Corporation: A C corporation is the oldest and most common business structure in use today. With proper documentation, a corporation is considered legally separate from its shareholders, officers, and directors. Subject to its own tax rate, a corporate income tax return is required.

The “C” corporation has unique tax benefits that are not available in any other structures. These benefits include;

Deduction of fringe benefits for corporate employees.
100% deduction of medical insurance/disability insurance and a limited deduction of life insurance.
Ability to adopt a formal Medical Reimbursement Plan and deduct the cost of reimbursing employees for their out-of-pocket medical expenses.
The first $50,000 of net income is taxed at only 15%.

With many tax benefits, a “C” corporation does have a few drawbacks, such as:

Payment of a salary may be required to take money out.
Net losses stay inside the corporation and do not flow down to shareholders. Instead, losses are carried forward until offset by future corporate income.
There is potential for double taxation; however, this can be avoided! Double taxation occurs only if earnings are distributed to shareholders as dividends. To avoid this, corporate earnings can be taken as deductible wages, interest repayments on shareholder loans, matched 401(k) plan contributions, and profit sharing contributions.

Common myths of using a “C” corporation are:

A requirement to take a dividend.
The IRS will treat the entity as a “Personal Holding Company” and tax earnings at a flat 35% tax rate.

Limited Liability Company: A Limited Liability Company, or LLC, is a relatively new structure compared to the corporation. After its conception, many were concerned about its lack of case law. This valid concern was quickly overcome when courts started defaulting case law to the much older Limited Partnership or LP. This change was very beneficial for the LLC but made the use of an LP obsolete. In an LP, only the limited partners have liability protection, holding the General Partner liable for all actions of the LP. In an LLC, all members have limited liability protection.

When properly formed with adequate documentation, the LLC is considered legally separate from its managers and members. The LLC may offer you unique asset protection not found in a corporation. This type of protection is called “Charging Order Protection”.

The LLC, by far, is the most flexible entity from a tax standpoint. After the IRS enacted the “Entity Classification Election,” or “Check-the-box Election,” the LLC was then able to elect to be taxed as a sole-proprietorship/disregarded entity, partnership, and C corporation or “S” corporation. Please note: Classifying an LLC as a sole-proprietorship or disregarded entity is never recommended for trading.

Most trading LLCs are classified as a partnership for tax purposes. The benefits of partnership or flow-through tax treatment in an LLC are:

Ability to use capital losses that occurred prior to the establishment of the LLC to offset future LLC capital gains.
Income retains tax treatment when passed to members/owners. In particular, trading activity such as the beneficial I.R.C. 1256 Contract tax treatment, retains the 60/40 split on the individual owner’s tax returns.

The only potential downside of trading in an LLC is:

The requirement of two owners which are needed for partnership tax treatment and separate legal entity status. Beware of using a single member LLC, as it will be classified as a disregarded entity for both tax and legal purposes.

Common myths of using an LLC are:

Profits are subject to the 15.3% employment tax. This fallacy typically originates from CPAs with a lack of knowledge in trader taxation. Per IRS Publication 550, trading gains are not treated as earned income or subject to employment tax. What’s more, the LLC passes profits to members retaining the original tax treatment.
LLCs do not have enough case law. In the past, this statement was true. The LLC defaults to partnership case law unless it has only one member.

Choosing the right entity structure for your trading business and adhering to its formalities may help you obtain “Trader Status” and provide access to valuable deductions not available to individual taxpayers. Why not use the tax code for your benefit? By legally decreasing Uncle Sam’s take, you are able to increase trading capital; therefore, increasing your chances for trading success.

Remember, any worthwhile dream does not come easy and there is no such thing as “easy money”. What separates successful traders from failures is those who treat their activity as a true business. Trading as a business will help you remove the emotion that adversely effects trading decisions and will provide ultimate cash flow management.

Which structure is right for you?

Receive your free personalized “trader tax plan” based entirely off your individual situation. Learn how to reduce your taxes and take control by downloading our questionnaire located here.