One of the questions I get quite frequently is whether a trader should incorporate their trading business. 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. Other traders, who have full time, W-2 jobs, worry that the IRS will disallow their trader status if they don’t trade through a corporation. 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
PROS
So when does it make the most sense for a trader 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 don’t create earned income through a corporation, you have to deduct your healthcare expenses on your Schedule A, and they are subject to a 10% floor (starting in 2013). For instance, if you made $100,000 trading and had $11,000 in medical expenses for the year, you would only be able to deduct $1,000 [$11,000 – ($100,000 x 10%)] if you didn’t have earned income. If you incorporated and paid yourself a salary, you’d be able to deduct the entire $11,000 off of your taxes! There are some nuances on how this is handled depending on whether you have a partnership, LLC, or S-Corp, so please consult with a qualified tax advisor regarding your personal situation.
If you still have questions on whether incorporation makes sense for your trading business or not, I do offer free consultations to review your personal situation. I can be reached at info@TraderTaxCoach.net or 888-61-TAXES to schedule an appointment.