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Personal Finance > GreenTraderTax.com

Recession ushers in new traders

GreenTraderTax | Thu, 08/06/2009 - 1:30pm |  3 comments

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April 29, 2009

Second article of a multi-article series which started on April 28, 2009 (see below post).

The recession has brought a record number of job losses, but it also means a rise in the number of individuals launching a trading business for the first time. The active retail trading industry is growing more than ever, just as it did in the early-2000s recession. Many people who have lost their job have turned to trading as a new source of income. These newbie traders often enroll in trading schools or seminars. It’s a great idea to do this before launching a full-fledged trading career — there is much to learn. However, be wary of some of the tax information given out in these schools and seminars.

Aspiring traders often pay $5,000 to $25,000 or more to attend trading academies and schools, and many never successfully establish a trading business that qualifies for trader tax status. Perhaps to help sell tuition to these aspiring traders, many school curriculums tie in with some trader-tax service providers (not GreenTraderTax) who promise “get-(tax)-rich-quick” schemes.

Some may suggest setting up two entities — an LLC and C-Corp. They say the C-Corp opens the door to deducting tuition as a business expense, no matter what happens with trader tax status. This scheme doesn’t work without trader tax status because the LLC pays the C-Corp a fee and then the LLC doesn’t qualify for business expense treatment.

In addition, tax law states traders are only entitled to deduct education and travel-related costs after they have commenced their trading business operations and qualify for trader tax status. The problem is that most traders incur these education and seminar expenses before they qualify for trader tax status. Some education-related expenses may be squeezed into Section 195 start-up expenses.

Patience is a virtue
The best advice: Wait to determine if your trading plan qualifies for trader tax status. Many plans do not. Next, give yourself some time trading to see if you can successfully launch an active trading business. If you qualify and have a successful business launch, then — and only then — you should consider a new trading business entity. At that time, all you need is one entity and it should be as simple as possible.

Many education firms also partner with brokerage firms, where graduates are given incentives to open trading accounts. The broker offers reduced commissions offsetting tuition costs over time. This raises an interesting tax accounting question. If tuition is not otherwise deductible as a business expense, can the trader recharacterize the tuition cost as commissions and thereby get a deduction through reduction of trading gains? Questions like these are best left to trader tax experts.

Forming an entity
We recommend a simple pass-through entity, such as a husband-wife general partnership, or a single-member LLC in your home state electing S-Corp. tax status. The entity will help you to claim trader tax status, elect Section 475f MTM later in the year, and have the key AGI deductions for health insurance premiums and retirement plans.

The entity pays an administration fee; turning non-SE trading income into SE earned income. An administration fee is not subject to payroll tax compliance, unemployment insurance, and workmen compensation payments. There are some risks here, so consult a tax advisor.

You could add a C-Corp to the plan as a second entity if you need a medical reimbursement plan to receive the administration fee. Otherwise, the administration fee goes to your Schedule C.

Once you have a trading entity, or a rock-solid unincorporated Schedule C for your trading business, you can consider deducting your Section 195 start up costs, including some or all of your trading school and seminar costs. These costs can be amortized over 180 months and there is a $5,000 first-year expense election too.

If you don’t qualify for trader tax status, be realistic and don’t count on papering it over with a two-entity scheme. Qualification for trader tax status is not easy for many; the rules are very vague and the IRS is attacking trader tax status in more exams. However, many graduates of day trading schools go on to easily qualify and recover tuition and travel related costs. Consult a tax advisor on these more nuanced deduction and capitalization strategies.

More entity benefits
Unless they have another source of earned income, profitable business traders should set up their own trading entity to have the opportunity to financially engineer some earned income. But only enough earned income to deploy a retirement-plan strategy; when done correctly, traders can save more in income taxes than they cause themselves (fully at their own option) to pay in SE taxes.

We don’t advocate guaranteed payments, because the IRS audit manual challenges that practice in investment companies. It’s different as a trading-business company. The Armstrong vs. IRS tax court case also provides support on this front.

With a Mini 401(k) retirement plan, the trade off on an elective deferral retirement plan contribution is a net tax saving proposition; with income tax savings exceeding SE tax costs. Plus, you replace bad income taxes with good SE taxes (which provide social security and Medicare benefits in retirement).

Bottom line
If are looking to start a trading business during this recession, you are probably inundated with the army of trading schools, courses, and seminars out there. Many promise riches and pass along bad tax advice. You should consider setting up an entity only after you’ve become a proven, successful trader. You can deduct your reasonable start-up costs at that time as well. Always consult a trader tax expert for guidance.

Check back soon: Our next entry provides helpful information from a trader-tax examination we recently encountered. Our California-based trader was denied trader tax status. We’ll go over the IRS agent’s questions and why this particular trader was unsuccessful on the exam-level. We expect to win that exam on the IRS appeals-level.

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