Day Trader? Read This Guide to Avoid Unnecessary Day Trading Taxes
In this episode of Toni Talks, enrolled agent (EA) Toni Covey is joined by special guests Sergey Garayants, Esq. and Gary McHenry, CPA, to discuss how day traders can avoid overpaying their taxes.
Three Levels: Investors, Traders, & Dealers
When it comes to trading, there are three broad classifications: investor, trader, and dealer. An investor is not as focused on trading as their main source of income. Instead, investors focus on long-term returns over short-term profits. An investor is defined by the IRS as someone who buys and sells securities for appreciation. Put simply, trading is not considered a “business” at the level of an investor.
An investor is focused on the long haul, whereas a trader or day trader is focused on buying and selling stock on a daily basis. For traders, their trading activity is considered a business. Traders’ transactions look for profit over the short-term as opposed to the long-term. The IRS defines a trader as someone who seeks a profit from daily market movements. Part of how the IRS measures whether someone is a trader is their daily level of activity. In addition to the level of daily activity, the IRS also looks at the holding periods to determine whether someone qualifies as a trader. Furthermore, they’ll also consider the frequency and dollar amount of trades, as well as the extent to which trading is your livelihood.
Finally, dealers are those who purchase and sell securities to customers. In general, dealers are the entities that you would normally think of as brokers, like Charles Schwab. Dealers can also be individuals, however, this is less common.
Mark-to-market (also known as “fair value accounting” or “market value accounting”) means that you are required to report and recognize unrealized positions. Whether you’ve closed your position or not at the end of the year, you’re required to report on it as if you had. This is an election that many mistakenly believe must be made as a trader. A mark-to-market election is not required for traders, however. If you want mark-to-market tax treatment, you need to make that election on your tax return the year before you actually start reporting that way.
As a trader, you have options for how you’ll report your gains or losses. You need to be consistent with your choice after you’ve decided how you’ll report. Typically, capital gains are reported on your Schedule D and given the capital gains tax treatment. Capital gains tax treatment means that, if held for a short term, the gains are taxed at your ordinary income tax rate, but are not subject to self-employment taxes. If held for the long term, gains are treated more favorably at the capital gains tax rates of 0%, 15%, or 20%, based on your overall taxable income.
As a trader, however, you’re most likely not holding securities for long periods of time. This means that, if reporting on your Schedule D, your trades will be treated as short-term capital gains and taxed at your ordinary tax rate.
One of the downsides of making the mark-to-market election becomes relevant if you have a loss. Usually, you choose not to close a position because it’s not in a great position at that time, but with mark-to-market, you’ll still report that as if you did close the position. This means you may end up with a loss, and that loss will be subject to the $3,000 loss limitation against your ordinary income.
This is where tax planning becomes so crucial for traders. You might not have trading as your only source of income. Some folks will buy a stock and hold it as an investment rather than use it in trading. In that case, you may want to move the stock as a distribution and put it into an investment account. This will allow you to generate capital gains and losses from the investment side, which could be used to offset some of your trading. This is just one example of how tax planning and trading should go hand-in-hand.
Traders’ Options for Reporting Income and Loss
As a trader, your trading activity is considered a business. This means that you’ll be reporting your expenses related to trading on Schedule C. As just an investor, all your capital gains and losses are reported on Schedule D. Your investment expenses will be reported on Schedule A if you’re already itemizing.
One of the things that changed with the Tax Cuts and Jobs Act is the elimination of the 2% floor deduction. This means that a lot of expenses (such as managing fees) are no longer allowable on Schedule A. But as a trader, you’re allowed to take expenses related to trading activity on Schedule C and have capital gain or loss on your Schedule D.
Another option for traders is to report income or loss on your Schedule C. In this case, you’re subjecting yourself to self-employment tax. Some traders make this choice because they’re concerned about their golden years and want to ensure they’re paying into Social Security (so that they can later draw upon those benefits).
Furthermore, if you’re reporting the actual trading activity on Schedule C instead of Schedule D, you are not subject to the $3,000 limitation on loss as you would be if you treated it as a capital loss. Instead, it’s treated as an ordinary loss on Schedule C. This makes it 100% deductible against any other income you may generate.
Entity Structures for Traders
As IRS guidance and regulation changes over the years, here at Anderson, we’ve developed entity structures for traders that have evolved and changed along with IRS mandates. One of the first recommendations we make to traders is: never trade in your own name. From a liability standpoint, stocks and similar investments will be treated as cash in your personal assets if held in your personal name. This means that, should anything happen and you are sued or get in a car accident or something, you won’t have any liability protections, resulting in your personal creditors being able to garnish your dividends or cash you may hold in your trading account.
At the minimum, we recommend forming an entity from which to conduct your trades. For this scenario, a disregarded limited liability company would be the first step. You (or you and your spouse, depending on your situation) will be the sole owner. This is not the preferred way, but it provides a baseline level of protection.
If you want to avoid self-employment taxes, another option is to use a partnership structure with a three-party arrangement. At the top, you’ll have an LLC formed in a strong asset protection state, like Wyoming. The partnership will consist of your LLC as the member and a C corporation as the managing member. These are just two possibilities among many for structuring trading activities.
This is just one example of a potential trading structure. Ultimately, you’ll want a structure that’s customized to your individual activity and goals to make sure you don’t get into trouble with the IRS or have a major tax headache on your hands.
If you’re ready to discuss the best entity structure for you with an experienced and knowledgeable Senior Advisor, schedule your complimentary Strategy Session today. On the call, you and a Senior Advisor will build the best custom entity structure for you. If you’d like, we can even implement your plan, too. You can schedule online or by calling 888.871.8535.