FACTORS AND ADVANTAGES TO CONSIDER ABOUT CREATING A TRADING ENTITY
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 fulltime job.
A THOROUGH ANALYSIS IS ESSENTIAL TO DEVELOPING THE PROPER STRUCTURE.
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 necessary.
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 State tax forms. 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 insurance.
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 requirements, etc.
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 businesslike 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 K1 that allocates income and expense to each individual partner. Each partner pays his/her taxes based upon the prorate allocation of income and expenses (profits/loss) as indicated on the K1.
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 choose 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 choice.
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 12%) 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 K1. As a flowthrough 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 musbe 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 value.
From an asset protection standpoint, the charging order is perhaps the greatest feature of both FLPs and nonfamily 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 multimember 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 memberLLC 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 multimember 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 nontax 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 shareholders.
All corporations (both Cand 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 CCorps 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 bylaws 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 CCorp’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, CCorps 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 CCorp is subjected to a separate tax rate structure, a Subchapter S Corporation is taxed on the individual shareholders’ personal tax return. The flowthrough nature of this entity makes it an ideal vehicle for trading. Since the income remains capital gains in nature it is not subjected to selfemployment 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.
SCorps, do, however, have some limitations. Key tax limitations include the nondeductibility 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”. Michael Steinhardt.
One of the chief characteristics of hedge funds is their ability to use nontraditional 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 ‘skillbased’ 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 underlying markets.
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 investor requirements.
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 flowthrough 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 absolute.