Some traders worry that trading as a sole proprietor might be viewed negatively in the eyes of the IRS and could even trigger an audit. The audit rates for individual tax returns for FY 2016 was 1 in every 120 households.
Some traders, have full time, W-2 jobs, worry that the IRS will disallow their trader status if they don’t trade through an entity. There are even some traders who believe that the only way to get the benefits and deductions allowed with trader tax status is by incorporating their trading business.
Since there seems to be a lot of questions surrounding trading through a corporation, let’s take a look at the pros and cons of incorporating your trading business. In the process, I hope to show you when it makes sense and when it doesn’t.
First of all, you do NOT need to incorporate your trading business in order to get the benefits of trader tax status. You get just about every tax deduction (except for a few I’ll talk about later) as a sole proprietor trader as you would trading through a corporation. All a sole proprietor means is that you are filing a Schedule C with your Federal 1040 to claim your trading expenses. A sole proprietor is the default taxation method for all traders, unless you formally incorporate. So from a tax perspective, trading as a sole proprietor or trading through a corporation are about equal (with the exceptions below).
Let’s talk about the negatives of incorporating your trading business and then we’ll finish up with the positives and why a trader might chose to incorporate their trading business.
CONS
- Cost more annually to operate than a sole proprietor business
- Can add extra state taxes (CA Franchise Tax for example)
- More annual paperwork to submit
- Need to open a business checking account
- May be subject to increased professional fees from brokers/data vendors
PROS
- Ability to create “earned” income
- Ability to deduct health care expenses
- Ability to fund a retirement plan
- Ability to deduct 100% of your medical expenses with a Section 105 plan
- Audit rate is dramatically lower than sole proprietors
- Late mark-to-market election filings
- potentially qualify for the new 20% QBI deduction
So when does it make the most sense for a atrader to incorporate their trading business?
From my perspective, there are two primary reasons a trader might want to consider incorporating their trading business: audit concerns and earned income. First, if you are concerned about facing an audit, you might want to consider incorporation. Keep in mind that having a corporation does not guarantee you won’t get an audit, but the national audit rate of corporations is about one half of one percent, meaning your chances of getting audited are statistically a lot lower than if you filed a Schedule C for your trading business.
The second, and most predominant, reason that a trader should consider incorporating, in my opinion, is to create earned income. This would be the case for full time, profitable, traders who have no other source of income. The IRS views trading gains as “unearned” income, meaning that you cannot fund a retirement plan (great way to reduce taxes) or deduct health care expenses. You need “earned” income in order to deduct these expenses. By trading through a corporation, you can pay yourself a salary, creating the “earned” income needed in order to fund a retirement plan and/or deduct your health care expenses. These two deductions can amount to tens of thousands of dollars in business deductions on your tax return!
If you still have questions on whether incorporation makes sense for your trading business or not, we offer consultations to review your personal situation.
Updated 1/14/2019