FACTORS AND ADVANTAGES TO CONSIDER ABOUT CREATING
A TRADING ENTITY
- Asset protection from creditors or litigants
- Section 475 Election Availability
- Tax Deductions from Section 419 Plans
- Tax Savings from Planning Strategies
- Fringe Benefits Allowable
- Retirement Planning
Every trader is unique with different needs and different
fact patterns such as their assets and liabilities, family considerations, state of
residence, etc. Your trading business and entity structure must be custom tailored to meet
your particular circumstances. A 29 year old single scalper with gains of $300,000 a year
has different needs than a 45 year old married Momentum Trader with 3 children and a
A THOROUGH ANALYSIS IS ESSENTIAL TO DEVELOPING THE
The Sole Proprietorship is the most commonly used form of
business in America. This is primarily due to the fact that it is the easiest to establish
and operate. There are no governmental filings required. Some localities may require you
to obtain a local business license or a fictitious name permit if you intend to operate
the business in a name other than your personal name. These licenses or permits usually
have nominal fees ($25-$50) and for trading businesses they are often not relevant or
An individual who is a qualified trader and is trading
through brokerage accounts in his/her individual name is considered a sole proprietor. You
are also considered a sole proprietor if you have a joint account with your spouse or any
other individual and have not created a partnership or other entity. The trader/proprietor
for tax purposes is the individual making the trading decisions. Sole proprietors report
their income and expenses on Schedule C which is included within their 1040 Individual
Income Tax Return. Traders complete Schedule C differently compared to other businesses.
The expenses of your trading business are reported on Schedule C. Income remains capital
gains (as opposed to ordinary) income and thus is reported on Schedule D. The exception to
this rule is for Traders who make the §475 Mark-to-Market election. If this election is
made then your ordinary income from trading is reported on Form 4797.
A sole proprietor Trader is allowed to deduct
dollar-for-dollar his/her trading expenses. You are exempt from the 2% threshold for
investment expenses to which Investors are limited on Schedule A. You can deduct an office
in your home and you can expense expenditures for depreciable equipment. While all trading
expenses are fully deductible, there are certain limitations on other type of business
expenses. For example, a sole proprietor cannot deduct the cost of health and disability
One of the main reasons so many people choose the sole
proprietor form of business is the ease of operation. As your own boss you can basically
do what you want, when you want. You don't have to answer to shareholders or directors as
with corporations, or to partners as with partnerships. Additionally, there are no
formalities such as shareholder or board of director meetings, minutes, annual filing
As stated above, sole proprietorships are restricted as to
some of the expenses they are able to deduct. Specifically, for Traders, since your income
remains capital gains in nature it is not eligible for retirement plan contributions (e.g.
IRAs, SEPs, etc.). From my experience, the problem with most sole proprietorships is that
due to their informal nature Traders tend to forget that they are actually businesses and
fail to operate them in a business-like manner. Failure to have a written business plan,
documenting business decisions and commingling business and personal funds - paying
personal expenses from the business account can be some of problems.
Where two or more people are joined in a business enterprise
a partnership is formed. By definition, two or more people (or entities) are necessary in
order to form a partnership. The key feature of a General Partnership is that it is an
informal arrangement between the partners. Again there are no governmental filing
requirements necessary to form a general partnership - a simple handshake will do.
Partnerships are considered "flow through"
entities for tax purposes. This means that as an entity the partnership does not pay
taxes. A partnership tax return is filed for informational purposes only and each partner
receives a Schedule K-1 that allocates income and expense to each individual partner. Each
partner pays his/her taxes based upon the pro-rata allocation of income and expenses
(profits/loss) as indicated on the K-1.
As with sole proprietorships, general partnerships are easy
to operate. There are no formal requirements for decision making.. Management of the
company is essentially by mutual assent. While the partners may chose to put the terms of
their agreement in writing, this is not legally required. The easiest way to view a
partnership is that it is a sole proprietorship among two or more people.
The most significant reasons NOT to form a general
partnership are the legal implications rather than tax considerations. In a general
partnership each partner is deemed to be an agent of the other partner and of the
partnership. Thus each individuals is able to bind the other individual. How does this
affect Traders? If two individuals decide to pool their money and open a brokerage account
which both of them are authorized to trade, each partner will be bound by the trading
decisions of the other partner. If Partner 1 enters into a losing trade, Partner 2 is out
of luck. However, the situation could be even worse. If Partner 1 trades the account on
margin and the account is subjected to a margin call, Partner 2 can be required to pay the
full amount of the margin call (not just 50%) and this is true even if he had no knowledge
of Partner 1's actions.
Due to this liability factor alone, we do not recommend
general partnerships except in very, very limited circumstances. Where a partnership among
two or more people is desired the Limited Partnership is typically the preferred entity of
Limited Partnerships are the preferred structure for
conducting business in partnership form precisely because of the liability issues
discussed above. Limited partnerships are comprised of one or more Limited partners whose
liability is limited to the amount of their partnership investment, and a General partner
who assumes unlimited liability. To take advantage of the separation of liability, the
general partner is typically issued a very small percentage of ownership in the entity
(perhaps 1-2%) so as to further reduce the vulnerability to creditors. To form a limited
partnership you must file a certificate of organization in the state in which you desire
to form the business. Partnership Agreement Limited Partnerships are creatures of statute.
All states have enacted statutes (laws) authorizing the establishment of limited
partnerships. A key feature of limited partnerships is that they require a written
partnership agreement. These Agreements govern the management and operation of the
partnership. Provisions of these agreements determine the manner in which partners may be
admitted or withdraw, the method of allocating profit and loss, and the manner in which
decisions are made. Thus, they are a bit more complex than general partnerships but the
advantages far outweigh the disadvantages. Tax Treatment The IRS requires the filing of an
informational return, however, income/loss is apportioned to each partner on a K-1. As a
flow-through entity, the limited partnership itself does not pay taxes. The income
allocated to the partners retains the same character as the type of income was earned by
the partnership. Thus, if trading income is short- term capital gains to the partnership
it will be treated as short term gains to the individual partners. Operation The central
feature of the Limited Partnership is that the limited partners' liability for debts and
obligations of the partnership is limited to their financial investment. This limitation
results from the separation of the limited partner from the control of the asset. Control
is vested with the General Partner who assumes unlimited liability. By statute and in
accordance with the terms of the partnership agreement, the General Partner is responsible
for the control of the partnership's assets. That is, the general partner is the one who
actually trades the accounts. The general partner can be either an individual or another
entity such as a corporation, limited liability company, limited partnership or other
entity. Limited Partners must be very careful not to actively participate in the
management of the partnership or they might lose their limited liability protection.
Since limited partnerships are required to be registered
with the state there are governmental reporting regulations and fees involved which vary
from state to state.
Family Limited Partnership
When all or most of the members of a limited partnership are
members of the same family a Family Limited Partnership (FLP) can be formed. FLPs are not
defined by statute but by the terms of the partnership agreement. They are organized and
operated just the same as Limited Partnerships as previously discussed. The distinguishing
features of FLPs are found in the terms of the partnership agreement and the tax
strategies that they can use.
FLPs are most commonly used for estate planning purposes.
Key among these is the ability to shift partnership shares (and income) to family members
in lower tax brackets, the ability to use discounted valuation, and the asset protection
feature of the "charging order".
With an FLP a parent can transfer shares of stock to
children and other family members who are in a lower tax bracket. While the income
attributable to the child's shares will be taxable at the child's rate, there need not be
any corresponding right of the child to actually receive the cash value of the shares.
CAVEAT: Beware of the "kiddie tax" under which income over threshold amounts
will be taxable at the parent's higher rate for children under the age of 14.
Due to the partnership agreement's restrictions on the
transfer of the partnership interests, it is frequently argued that the true present value
of the shares are less than the value of the underlying assets. This is important for
estate planning purposes as it may effectively allow a parent to transfer to children
assets having a value greater than the amount discounted minority partner's appraised
From an asset protection standpoint, the charging order is
perhaps the greatest feature of both FLPs and non-family Limited Partnerships.
Essentially, while the creditor of a limited partner may be able to acquire a limited
partner's partnership interest, that alone does not make the creditor a limited partner
and does not give him/her any rights of a partner. Most importantly, the creditor does not
receive the right to force the general partner to make a distribution of income. Even
though the creditor does not actually receive cash from the partnership, it can still be
required to pay taxes on the distributive share of partnership income.
Limited Liability Company
Limited Liability Companies (LLC) are essentially a hybrid
between corporations and limited partnerships. Similar to corporations and limited
partnerships, LLC members' interests are limited to the amount of their investments. LLCs
are relatively new on the entity scene having made their debut when Wyoming established
the first statute in 1977. Currently, they are authorized by nearly every state.
An LLC has the choice of being taxed either as a partnership
or a corporation. As a partnership the income/loss flows through to the individual members
and is reported on their personal tax returns. As a corporation corporate tax rates and
rules apply. LLC's can be either single-member or multi-member in nature.For tax purposes
the IRS disregards single member LLCs and some states don't authorize them. The effect is
that while a single-member LLC may enjoy asset protection, it will continue to be taxed as
a sole proprietorship thus requiring the filing of a Schedule C and in some cases a
Schedule SE on which the 15.3% self-employment tax must be reported and paid. A
multi-member LLC is taxed more like a limited partnership, in which income is generally
not subject to self-employment tax. In the event the LLC is member-managed (as opposed to
"manager-managed"), the managing member may be subjected to such tax.
A key difference between LLCs and Limited Partnerships is
that whereas a limited partner may lose his limited liability protection by participating
in the management of the partnership, the member of an LLC is permitted to participate in
management. Thus, an LLC can either be "member managed" or "manager
managed". Management is in accordance with the Operating Agreement and state laws.
While there are some advantages to utilizing these entities
there are also disadvantages. Since the LLC is a relatively new entity structure there
have not been a great deal of court cases deciding the tax and non-tax implications of
this form of doing business, although the laws are become more defined in this area. While
the statutes mirror the Limited Partnership statutes in many respects there are
significant differences. Therefore, careful analysis and planning must take place on a
case by case basis to determine which is appropriate.
Corporations - In General
There are two type of corporation: S-Corporations and
C-Corporations. All corporations when organized begin as C-Corporations. A special
election can be made with the IRS on Form 2553 electing S Corporation status for tax
purposes and have its income/loss reported on the individual tax returns of its
All corporations (both C- and S-Corporations) share similar
characteristics. They are created by state statutes and are the only business entity
considered and treated as being totally separate and distinct from their owners (i.e.
shareholders). They are the most complex structure to formulate and maintain and require
the most formalities for their continuation and validity. Though more complex than other
forms of doing business, the requirements are by no means unmanageable and in fact,
corporations provide the greatest tax advantages for businesses - particularly Traders.
C-Corps receive the widest array and highest limits of tax
deductions of any business entity. There is far more flexibility in establishing 419
trusts, retirement plans, deducting travel and entertainment and seminar expenses, paying
medical and educational expenses with tax deductible dollars and many other benefits which
are either unavailable or severely limited in other forms of business.
The most frequently heard disadvantage about C-Corps is the
double taxation issue. The argument is this: as a separate entity the income of a
corporation is subject to taxation at the corporate level and then is taxed again at the
individual level when paid as salary or dividends. This is not totally accurate because it
fails to take into account that salaries are deducted from the corporation's income before
the corporation is taxed, thus to the extent salaries are paid there is no double
taxation. Dividends, however, are not deductible by the corporation, however, through the
use of proper planning and implementation of corporate programs, dividends and double
taxation can be avoided or minimized.
Even where corporate income is taxed, at all levels the
corporate tax rate is lower than individual tax rates on the same income. Compare the
corporate tax rate of 15% on the first $50,000 of income, while the single individual tax
rate is 15% on the first $25,750 and thereafter jumps to 28%.
Corporations are created in all states by filing articles of
incorporation and paying the required fees. They are governed by by-laws that are the
internal documents of the company. Corporations are by far the most complex to manage due
to the requirement of annual and special meetings of shareholders and directors and the
requirement that all significant decisions be documented in written resolutions. These
requirements are by no means unmanageable and companies exist which can assist
corporations in complying with these requirements.
Although a corporation can transact business in any state of
the country, there are complex rules regarding nexus and apportionment of income that must
be complied with. Also, of particular importance to Traders, if 60% or more of your
C-Corp's income is derived from trading it may be considered a Personal Holding Company
and subjected to a 35% tax rate. If your sole business is trading, C-Corps should not be
used without first consulting with competent accounting and legal professionals to
implement strategies to avoid this result.
S-Corporations are the same in structure, management and
operation in all respects except taxation.
Where as a C-Corp is subjected to a separate tax rate
structure, a Subchapter-S Corporation is taxed on the individual shareholders' personal
tax return. The flow-through nature of this entity makes it an ideal vehicle for trading.
Since the income remains capital gains in nature it is not subjected to self-employment
tax.. A second reason for establishing an S corporation is that of asset protection.
Anybody suing the individual trader would not generally be able to get to the assets of
the S Corporation. On the other hand, anyone suing the S Corporation would not be able to
get at the assets of the Trader outside of the corporate entity, provided however, the
corporate entity is properly maintained.
S-Corps, do, however, have some limitations. Key tax
limitations include the non-deductibility of disability premiums, limitations on
deductibility of medical insurance premiums for shareholders, and heightened scrutiny on
the employment of family members. Additionally, there can be no more than 75 shareholders.
As with all corporations it is essential that the "corporate veil" be
maintained. If it can be demonstrated by the IRS or other creditors that the corporation
is not being conducted as a separate legal entity and is merely the "alter ego"
of the shareholder, the tax benefits and asset protection features will be lost.
Frequently Traders desire to manage the investment
portfolios of others. The reasons for such a venture are numerous. A couple of the most
often cited reasons are: (1) the Trader has been asked by friends and family members to
manage their portfolios; or, (2) the Trader desires to increase his profitability by
receiving a incentive fee based upon the performance of a much larger trading account. In
such situations it becomes ever so important that the venture be structured properly to
protect both the Trader and Investor.
The first hedge fund was started in 1949 by Alfred W. Jones,
who gave the fund its name. Jones' hedge fund was novel in combining for the first time
three previously available instruments. It used a private partnership as the legal vehicle
for maximum flexibility, sold stocks short, and used leverage. Jones reasoned that having
both long and short positions in a portfolio could increase returns while at the same time
reduce risk due to less market exposure. Leverage could further enhance these effects.
While many of the private investment funds today no longer
utilize hedging strategies or do so to a lesser degree, the term "hedge fund"
continues to be used today. For the purposes of this explanation, the term hedge fund will
be used to describe any private investment fund organized as a partnership and utilizing a
performance based fee structure (whether or not hedging strategies are used to protect
against market risks).
Some of the better known attempts at defining what a hedge
funds is include:
"A mutual fund that employs leverage and uses various
techniques of hedging". - George Soros
"A limited partnership in which the general partner is
typically paid on a performance basis...the manager of a hedge fund has a great deal more
flexibility than a traditional money manager, and that is really the key element". -
One of the chief characteristics of hedge funds is their
ability to use non-traditional investment instruments and techniques. Hedge funds are
lightly regulated pools of investment capital, with no or little restrictions regarding
asset classes, investment techniques, or the use of leverage. In contrast, mutual funds
are highly regulated and typically fail to have the same breadth of instruments at their
disposal (particularly leverage and the ability to go short).
Hedge funds provide the money manager/trader with a more
efficient vehicle for 'skill-based' investment strategies. The typical hedge fund manager
has been seasoned for many years as a trader in a top Wall Street firm or mutual fund firm
before deciding to go into business for themselves by starting a hedge fund. Hedge fund
managers then typically charge a performance related fee focusing on absolute returns, in
addition to charging fixed fees for the administrative costs. Hence, investors in hedge
funds rely on, and reward, the skill of the manager rather than the movements of
Over the past fifty years these private funds have become
extremely popular, primarily due to the success and notoriety of fund managers such as
George Soros and Michael Steinhardt, coupled with the fact that they have significantly
outperformed the market in general and many of the best known mutual funds.
Although generally unregulated, there are several federal
and state statutes which must be considered in structuring a Hedge Fund. The regulatory
framework that generally governs hedge funds includes the following:
Securities Act of 1933: Interests in hedge
funds are not registered under the Securities Act of 1933 as amended, or any other
securities laws, including state securities or blue sky laws - assuming the fund is
structured properly to take advantage of applicable securities acts exemptions. Instead,
hedge fund interests are offered in reliance upon the exemption from registration provided
by Section 4(2) of the Securities Act of 1933 and Regulation D promulgated thereunder.
Prospective purchasers are required to represent that they are "accredited
investors" as defined in Regulation D and that they are acquiring the interest for
investment purposes only and not for resale or distribution.
Investment Company Act of 1940: Hedge funds
are subject to the Investment Company Act of 1940. The number of beneficial owners of
interest, for purposes of the Investment Company Act of 1940, as amended, is limited to
100 or less so as to qualify for the exemption from the provisions of the Investment
Company Act. With respect to the determination of the number of such beneficial owners,
hedge funds must obtain and rely on appropriate representations and undertakings from each
limited partner in order to assure that the fund meets the conditions of the exemption on
an ongoing basis.
Investment Advisers Act of 1940: Some
general partners of hedge funds choose to register as investment advisors (or are already
investment advisors) under the Investment Advisers Act of 1940. Others do not in reliance
upon the exemption from the registration requirements of the Act contained in Section
203(b)(3), which exempts from registration any investment adviser who during the course of
the preceding 12 months had fewer than 15 clients and who meets certain other
requirements. General partners who register may be subject to both various fee
restrictions contained in the Investment Advisers Act and more stringent accredited
State Blue Sky Laws: In addition to the
federal laws, each state has its own statutes and regulations ("blue sky laws")
governing the offer and sale of securities into or from such states or to residents of
such states. In many states, filings must be made to qualify for an exemption from
registration. While the majority of states have adopted in some form the Uniform
Securities Act of 1956, and several states have adopted in some form the Revised Uniform
Securities Act of 1985, the particular laws of each state differ, and compliance with a
state's blue sky laws must be determined before any offer is made into, from or to a
resident of such state.
Historically, hedge funds for US investors have been formed
as limited partnerships. Over the past several years, however, nearly all states have
passed legislation approving the limited liability company (LLC) as an entity which
provides liability protection to investors as well as flow-through taxation. Funds may be
organized using this form as well. It is recommended that the general partner of a limited
partnership should be structured as either a corporation or LLC, this is to help protect
the general partner who has unlimited liability. It should be noted, however, that due to
laws concerning fraud and other securities laws this liability protection may not be