Many say that to succeed in trading, you need to ‘treat it like a business. If you’re trading full-time or aiming to, setting up the right entity is a key step for building a solid business framework.
While hobbies cost money, businesses generate income—and the same idea applies to a trading business. A day trading business isn’t about selling products or services; it’s about capturing profits and, most importantly, unlocking tax benefits that only come when you structure your trading as a business.
Turning day trading into a business is about more than just trading profits; it’s about tapping into tax benefits that hobby traders miss out on. With the right setup, you’ll get asset protection and tax savings that help you hold onto your earnings. For a deeper dive into the tax implications, check out a CPA’s insight on Navigating Day Trading Taxes.
Not every trader needs an LLC for day trading, but for those who do, here’s how it can help:
- Separate personal and business assets, offering liability protection.
- Deduct business expenses tied to trading (e.g., home office, margin interest, market data, stock borrow fees, education, and mentorship).
- Make a “late” Section 475 Mark-to-Market (MTM) election to bypass wash sales and the $3,000 capital loss limit.
- Qualify for a 20% Qualified Business Income (QBI) deduction on Section 475/TTS income.
- Generate earned income (e.g., W-2) for retirement plans (like a solo 401(k)) and health deductions.
- Deduct state and local taxes (SALT) as business expenses, avoiding the $10,000 SALT cap.
Entity Choices for Day Traders
1. Single-Member LLC (SMLLC)
For asset protection, consider forming a single-member LLC. Treated as a “disregarded entity,” an SMLLC functions as a sole proprietorship for tax purposes. Individuals who trade as SMLLCs report business expenses on Schedule C, while trading income/losses are reported on other tax forms (such as Form 8849, Form 4797, or Form 6781). Note that SMLLC owners don’t need to meet Trader Tax Status (TTS) guidelines to access business treatment since SMLLCs are inherently treated as businesses.
2. LLC Taxed as a Partnership
Day traders structured as multi-member LLCs file taxes using Form 1065, which simplifies tax filing. Form 1065 generates a Schedule K-1 for each owner based on their ownership percentage, with taxes paid at the owner level instead of the entity level, thereby avoiding double taxation. Net income is summarized on Schedule E rather than in detail on Schedule C, as used by sole proprietorships.
This structure provides benefits, such as separating personal and business assets and offering a workaround for the SALT cap. However, filing a Form 1065 does “not” allow for employee benefit plans or 401(k) contributions. Note that an LLC owned by spouses (husband and wife) can also be taxed as a partnership.
3. LLC Taxed as an S-Corp
Multi-member LLCs and SMLLCs can elect S-Corp tax treatment within 75 days of formation. Choosing S-Corp taxation offers additional benefits, such as deducting health insurance and retirement plan contributions. You’ll also gain access to SALT cap workarounds and can pay yourself a salary, which generates “earned income” for further tax benefits.
Note that a base salary is required to cover deductions and health insurance premiums. For 2024, if you have significant trading gains, the elective deferral limit is “$23,000”, with a maximum profit-sharing contribution of 25%, totaling “$69,000”.
An S-Corporation is generally tax-free at the federal level; however, some states impose taxes and annual reporting fees. For example, here in California, the S-Corp “tax/annual fee” is the greater of $800 per year or 1.5% of the S-Corp’s taxable income. S-Corp majority owners are not eligible for health reimbursement arrangements (HRAs).
However, S-Corps can offer HSAs/HRAs as benefits to employees who own less than 2% of the business. The IRS considers S-Corp shareholders as “self-employed”, so owners who own more than 2% of the business cannot participate in an Individual Coverage Health Reimbursement Arrangement (ICHRA).
4. LLC Taxed as a C-Corp
Many active traders consider using a C-Corporation for trading or a dual-entity structure (such as a C-Corporation management company combined with an LLC). In a dual structure, if you can allocate enough income to the management company, this can optimize employee benefits, compensation, and net income.
However, due to fluctuations in day trading gains, C-Corps can present challenges, primarily double taxation—first at the entity level and then at the shareholder level—and potential accumulated earnings tax issues. This strategy’s effectiveness also depends on the taxpayer’s existing tax bracket, as C-Corps are taxed at a flat rate of 21%. For some, a C-Corp offers higher tax savings than an S-Corp. C-Corporation owners and their families may participate in HRAs, as the IRS considers C-Corps as separate legal entities. This designation makes C-Corp owners common-law employees of the corporation.
Final Thoughts
There is no one-size-fits-all entity solution for traders. Each trader’s situation is unique, so what works for one may not work for another. Also, if you form an entity outside your home state, you “may need” to register it as a foreign entity in your home state. Setting up a mailbox in a tax-free state doesn’t establish tax nexus—trading from your home state does. When preparing your entity tax returns, don’t try to avoid state-level taxation. For instance, if you live in Los Angeles and form an entity in Wyoming or Nevada but live and trade from here in California, California may charge LLC taxes, fees, and penalties.
Wondering about the right fit? Chat with one of our trader tax CPAs today for expert advice.
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