Avoiding Taxes on your Trading Profits
[tweetable alt=””]How’d you like to make $100,000 trading forex this year[/tweetable]…and then have the government take $53,000 of that in taxes? With the current U.S. capital gains tax rate as high as 39.6%, and with additional State capital gains rates up to 13% (California, of course), it could happen. I don’t know about you, but no way am I willing to give up over half of my hard-earned trading profits to the government (who didn’t help me earn one dime of them). Personally, I don’t think there should even BE a capital gains tax. (There’s not one in Singapore, which explains why so many millionaires/billionaires, like Facebook co-founder Eduardo Saverin, have renounced their U.S. citizenship and moved there.) But unless you’re planning to move to Singapore by Christmas, you’d better have a good plan in place for minimizing your tax bill. And a basic part of that plan should be forming a corporation or other business entity to do your trading through.
The simple fact is that business entities are much less at the mercy of the tax man than individuals are – for one thing, there are much stricter tax deduction limits on individuals than on businesses. Business entities also offer benefits such as the ability to establish retirement plans like a 401(k). Therefore, doing your trading through a business entity is one of the simplest and wisest steps you can take to protect your trading profits. Treating your trading as a business is also just good general practice, as it will get you in the habit of documenting your time, activities, and expenses as a trader.
There are, of course, several different options available as far as which type of business entity you set up. To help you choose which one is best for you and your style of trading, I recommend talking to a knowledgeable professional whose firm specializes in setting up corporate entities for traders – you can easily locate these types of firms with an online search. But let’s at least review the most common entities, to give you some idea of which one might work best for you. I’ll follow this up with some specific tax reduction tips.
Legal Business Entities for Traders
LLC (Limited Liability Company) – An LLC, which is taxed as a partnership, is one of the most popular business entities for traders, the only drawback being that as a partnership, it must have at least two members. (Get married!) An LLC is a “pass-through” entity. This means the income or loss from trading flows to the members and is reported on their individual income tax returns. One of the most important features of an LLC is that income from an LLC is not generally subject to payroll taxes, nor the crippling 15.3% self-employment tax. (Get the latest advice on this from a tax professional – Uncle Sam is always changing the laws to leave more for him, less for you.) Note: While most States allow single-member LLCs, the IRS does not look on these entities kindly (to say the least).
Sole Proprietorship (not usually recommended) – It’s the easiest business entity to form, but in this case simplest doesn’t mean best. There are several reasons for this. Sole proprietorships do not separate your business assets from your personal assets, thus putting ALL your assets more at risk. Also, tax deductions are often significantly more limited than they are for other business entities. And because of the IRS’ vague definitions of what constitutes a trading business, even just correctly filing your tax returns using this status may be enough to raise a red flag with that government agency (which does not have your best interests at heart).
C-Corporation – A C-Corp, often used for the easy ability to offer benefits like HSAs and FSAs (medical reimbursement plans), differs from an LLC in that profits are taxable to the corporation, rather than flowing through to the partners/members (thus making profits only removable through things like dividends or salaries).
S-Corporation - S Corporations, if your trading is profitable, usually have to pay salaries, at least to the owners of the corporation, which brings the headaches of payroll taxes and payroll reporting. For that reason, it’s not usually considered the best choice for a trading business entity.
The U.S tax code is hopelessly complex, and not designed to do you any financial favors. That’s why I think it’s important to set up your business entity with the help of a firm that specializes in assisting traders. One thing they can definitely help you with is taking all the deductions you’re legally entitled to.
Tax Deduction Tips
Here are just a few of my favorite, not-always-thought-of tax deductions for traders:
- Your cable TV or satellite bill – Is watching financial news channels essential to your trading business? – Of course it is! Then your expenses for accessing those channels make at least part of your cable or satellite bills tax deductible.
- Internet access – You can’t possibly trade without internet access, right? So don’t forget about deducting internet connection expenses.
- Every scrap of information you access to make yourself a better trader – Financial magazines, financial web site memberships, every book you read on trading, they’re all deductible expenses for your trading business.
- Phone bills – Do you use your phone (or maybe Skype) to discuss the markets with other traders? That’s another deductible business expense.
In conclusion, there are innumerable tax advantages for you as a trader when you conduct your trading as a business entity (and innumerable disadvantages if you just trade as an individual). Therefore, as soon as you are working with any significant amount of money in your trading, you should look to form a business entity to trade through. Again, I stress the importance of consulting a professional – what I’ve written here is to the best of my current knowledge, but may not be completely up to date with the ever-changing tax laws.
Finally, when you can, move to Singapore. That’s my plan.
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