Day traders, according to the IRS, are not investors. To qualify as a day trader, you have to approach buying and selling stocks and securities as a business. Day traders are taxed differently from investors, and if it makes financial sense, they can set up a day trading LLC or S corporation.
Tip
As a day trader, you can form an S corporation, C corporation or LLC. Whether it's worth it depends on your specific financial situation. If you want to self-incorporate, it's essential you can prove to the IRS you're a trading business, not just an investor.
Trader or Investor
You can call yourself a day trader all you like, but saying it doesn't make you one. It matters what the IRS thinks because trading in securities and investing in securities are treated differently at tax time. Securities include stocks, options, futures and similar investments. The day trader/investor boundary isn't clear-cut. Like a lot of tax questions, the standards are open to interpretation.
- The IRS says investors make their money from dividends, interest or capital appreciation. Traders make their profits from daily stock market movements, so their turnover is faster.
- Traders must have substantial trading activity and make trades continuously and regularly.
- The IRS considers factors such as how long you hold stocks, the frequency and dollar amount of your trades, the time you devote to trading, and whether you approach it as a way to support yourself.
You can invest in securities without disqualifying yourself as a day trader. However, you have to keep a clear separation between your trades and your investments. One way is by keeping investments in a separate brokerage account. Even if the IRS agrees you're a day trader, you report the results of your investments as capital gains or losses, not business income.
Day Trading and Taxes
If the IRS agrees you meet the day trading benchmarks the tax laws require, you're legally self-employed in your own business. You don't have to incorporate a day trading business; a sole proprietorship works too. As the Small Business Administration says, becoming a sole proprietor is easy. If you don't create a day trading LLC or S-corp for trading stocks, your business is a sole proprietorship by default.
Although you report trading profits as capital gains on Schedule D, Market Watch advises that day trading business expenses go on Schedule C. These expenses could include computer equipment or filing cabinets you use primarily for business or financial software for tracking your trades. If you have a home office for trading, you can get a write-off there, too. If the office takes up 7 percent of your house, you can claim 7 percent of your mortgage interest and utilities as a deduction.
Commissions and other costs of buying and trading don't go on Schedule C. Instead, you factor them in when you calculate the gains or losses from your trades. Because your income is treated as capital gains, you don't have to pay self-employment tax on it.
If you take the "475" election, named for the 475(f) tax rules, you get added benefits. As a 475 trader, you report the results of day trading as regular gains or losses instead of capital gains and losses. In a bad year, you can only deduct $3,000 of capital losses against other income, but under 475(f), you can deduct all your losses. The 475 "mark to market" rule also simplifies the complex accounting for buying a stock within 30 days of selling it at a loss.
Day Trading: LLC? S-Corp? C-Corp?
If your trading has reached the volume where claiming day trader status will withstand IRS scrutiny, you may want to consider shifting to a different structure than a sole proprietorship. According to the Forbes website, options include a C-corp, a limited liability company (LLC) or an S-corp. You might also be able to form a partnership.
While it's possible to incorporate your day trading business, it's not necessarily the best choice for every trader, so it's important to study the options and their pros and cons. A sole proprietorship is cheaper and easier to form than any other business type, but the tax paperwork for day trading is often more straightforward with other structures.
Another factor is the 475 election. A sole proprietor has to file paperwork no later than the regular due date for last year's tax return, not counting any extensions. If you decide to elect 475 later in the year, you can still do it by setting up a partnership or S-corp for trading stocks. As a new trading business, you then have 75 days to make the 475 election.
Partnerships, S corporations and sole proprietorships are all pass-through entities where the company profit is taxed as your personal income. Under current tax law, you can claim 20 percent of your business income as a write-off from your income on your 1040. The rules for traders are complicated, and you may need to go 475 to take advantage of the deduction.
Weighing Your Options
When considering partnership vs. LLC or S-corp vs. LLC for trading, it's best to take your time and consider all the options. Changing your structure once you're committed isn't easy. You should also be confident you can qualify as a trading business before you make an effort to establish a formal structure.
- Partnership. Legally, a one-person trading partnership isn't a thing. If you're married, though, you can form a spousal partnership even if you're the only one trading. This could be a general partnership or an LLC that files taxes as a partnership. A trading partnership's tax returns are simpler than a sole proprietorship and will probably attract less IRS scrutiny.
- S corporation. Unlike with a partnership, a single day trader can form an S corporation. First, you incorporate your day trading business, and then you elect to make it an S corporation instead of a C-corp for day trading. The big advantage of forming an S-corp for day trading is that you can deduct retirement plan contributions and your health insurance.
- C corporation. A one-person C corporation is an option but not a great one for day traders, Forbessays. The IRS can potentially charge higher taxes than you'd face as an S corporation.
- LLC. Other than liability protection, a limited liability company doesn't offer much in the way of benefits for day trading. You still report income on Schedule C, so nothing changes unless you elect to have the LLC treated as a partnership or an S corporation.
It's worth sitting and crunching a lot of numbers to decide where your best interest lies. For example, an S corporation is a lot more complicated to set up than a sole proprietorship and requires ongoing paperwork and fees. If writing off your health insurance makes a significant tax difference, it might be worthwhile to incorporate your day trading business; if not, sticking with a sole proprietorship might be smarter.
