Taxes for Traders

Is there any way to clearly define your trader tax status?

We have found that trading, as a formal business entity, is one of the best ways to protect your trader status. The IRS has two tax codes: one for businesses, the other for individuals. Because businesses grow money both by paying taxes and employing other taxpayers, they are rewarded and encouraged through a benevolent tax code. Individuals, however, are treated far more harshly by routine tax hikes and diminishing deductions.

When you file as a limited partnership, limited liability company or a C corporation, the IRS tends to treat you as a business. That's a good thing. Trading as an entity helps to stabilize your tax status as a business. You can trade as a sole proprietor, but we don't recommend it. You are far more vulnerable.

Do business entities offer other advantages to traders?

Absolutely. You can reduce your risk by limiting your liability to the assets you have invested in the business. You can set up a retirement plan that is deductible to the business and non-taxable to the members. As an entity, you can even elect mark-to-market after the deadline, as long as you note it in your minutes within two months of opening your business.

We've helped some traders combine an LLC with a C corporation for a tax-smart way to draw money out of the trading business without incurring payroll taxes.

Do the tax rules change if you trade in foreign exchange or the futures markets?

Yes, and for the better. As I mentioned, forex traders receive a significant tax advantage over securities traders. They are allowed to split their capital gains, with 60% taxed at the lower long-term capital gains rate, currently at 15%, and 40% at the ordinary or short-term capital gains rate of up to 35%.

That combined rate of 23% amounts to a 12% tax break. It becomes a little more complicated if you trade in cash forex. Suffice to say, most traders would be wise to consult an accounting professional who knows both taxes and trading for help in preparing their income tax return.

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