The Pros & Cons of Trading Through an Entity
In a recent blog post, I talked about some frustration I had when moving my trading accounts from a personal account to an entity account.
I now trade through my company StockWonk Trading LLC. My trading accounts are now in that name, rather than my personal name of James Krieger.
Why would I make this move?
The main goal was to generate earned income from my trading. Income from stock trading is not considered earned income. This means you can’t make retirement contributions from it, and if you want to apply for a loan, lenders won’t consider it. You could make $1 million per year and lenders won’t care. You also wouldn’t be able to reduce your tax burden with tax deferred retirement contributions like an IRA or 401K.
Houston We Have a Problem
I ran into this issue earlier this year when my wife and I decided to refinance our home (we were able to land a 2.75% rate on a 30-year fixed, which is INSANE…that’s lower than a lot of car loans). While I had plenty of income from my combination of trading and my Weightology business, the lender didn’t consider my trading income. On top of that, it actually showed less earned income than what I had actually made.
The way a trader does taxes is that you report all your trading expenses (like borrow costs, platform fees, etc.) on schedule C (i.e., profit/loss from a business). You report your trading profits/losses separately on form 4797 (sale of business property). You can’t report your trading profits on schedule C (this is according to IRS rules). Thus, as a trader, you will always show a business loss on schedule C since it only shows expenses.
Why is this a problem?
Schedule C is your earned income. Form 4797 is not. So any losses on schedule C will count against any earned income from other businesses reported on schedule C.
I like to short hard-to-borrow stocks. Thus, I pay A SHIT-TON in borrow fees. Those fees go on schedule C. In 2019, those fees, combined with other fees like from Scanz, were large enough where they ended up being half of my Weightology income. Thus, for 2019, my earned income got cut in half from trading expenses. Sure, my total income was good, but the portion of that income that was earned income was dramatically reduced. Remember, lenders don’t care about unearned income. Fortunately my wife’s income was high enough where it didn’t hurt our chances of refinancing, but I knew that I wanted to avoid this problem in the future.
Also, the reduction in my earned income dramatically reduced how much I could contribute to my SEP-IRA. In fact, I ended up overcontributing on the year and had to withdraw some of the contributions.
My 2020 trading profits were off to such an amazing start that I knew that the problem was only going to get much worse. In fact, it was highly probable that my 2020 trading expenses would be so high that they would wipe out all my earned income from Weightology, and perhaps even show a net loss by the end of the year. That would mean NO ability to make any tax-deferred retirement contributions.
Creating an Entity
Thus, I followed the advice of Green Trader Tax and set up an entity account to trade through. Specifically, I set up an LLC filing federally as an S-Corp.
How’s this work? I do all my trading in the company entity accounts. I am considered an officer of the company. I can then take profits and pay myself a salary from my own company. I use Paychex as my payroll provider. I can pay myself as much as I want to from my trading profits, and it will count as earned income. I also set up a solo 401K through Paychex and can make retirement contributions. On top of that, since I’m both the employer and the employee, it dramatically increases the amount I can contribute to my retirement. I can contribute up to the IRS limit of $19,500 as an employee, but then contribute an additional $36,500 as the employer through a profit-sharing plan. In other words, StockWonk Trading LLC shares its profits with me (yes, I know it’s me sharing my profits with me). Also, with my Weightology SEP-IRA, I can still contribute 25% of my Weightology income. This is a huge benefit. I can make a lot more retirement contributions than I could before, and significantly reduce my tax burden.
This is not to say it’s all roses when trading through an entity, but for me, the pros significantly outweighed the cons. Here’s a list of the pros and cons of trading through an entity.
- You can generate earned income from your trading.
- You can make retirement contributions from your trading income and reduce your taxable income.
- You can deduct health insurance plan costs from your trading income.
- You can contribute up to the $56K limit for 2020 through a combination of employee and employer contributions with a solo 401k.
- If you have a separate self-employed business, you can contribute even more to retirement (up to 25% of your self-employment income from the other business).
- You reduce IRS scrutiny as repeated losses on schedule C year-over-year can increase the risk of an audit.
- Your trading expenses won’t reduce your earned income like in the situation I described, and you won’t show negative earned income if trading is your only business.
- You’re considered a trading professional so you pay more in quote fees.
- You’ll pay social security and Medicare taxes on your earned income, which you normally wouldn’t pay on trading profits. However, the tax advantages of being able to make retirement contributions likely outweigh this, depending upon your situation. Plus, there’s a $137,700 cap on social security taxes so if you’re really killing it this year and you’re paying yourself more than that, you won’t pay social security taxes above that amount.
- You’ll have to hire a payroll company to process your payments. However, the cost is fairly small (I pay around $35 per month for mine).
- It will seem weird having a payroll company pay you when you feel like you could just transfer money between bank accounts. My payroll comes out of one business account and direct deposits into a personal account. I can’t just do a direct transfer; the payroll needs to process it for tax purposes.
- There’s a lot more paperwork involved when opening entity accounts, both with the brokers and the paperwork you need to file with your state. You also need to set up a business checking account in the name of the entity. It’s a much slower process than opening a personal account with a broker.
Whether it’s advantageous to you will also depend on the state you live in. I live in Washington State, which is one of the top 7 states for traders. This is because I’m exempt from Business and Occupation (B&O) taxes, and there is no state income tax. Check out this list of the best and worst states for traders in terms of taxes.
If you are a full-time trader or looking to be one, you may want to consider trading through an entity. Obviously you’ll need to weigh the pros and cons for yourself, the state you live in, and your situation. I recommend checking with the professionals at Green Trader Tax for more info.