Proprietary traders are significantly different from retail traders and have special tax compliance needs.
Proprietary traders are significantly different from retail traders and have special tax compliance needs. They don’t trade their capital. They trade the firm’s capital, usually accessed from a sub-trading account within the firm. A prop trader becomes associated with a prop-trading firm either as an LLC member (Schedule K-1), an independent contractor (1099-MISC), or an employee (W-2).
If you fall in the prop trader category, here’s what you need to know.
Independent contractors
Profitable independent contractor (IC) proprietary traders receive a 1099-MISC for “non-employee compensation.” Sole proprietors use a Schedule C to report fee revenue and deduct their business expenses, including home-office deductions, if they qualify. Schedule C net income is subject to federal and state income taxes…That net income is deemed “earned income” subject to the self-employment (SE) tax. They can deduct health insurance and retirement plan deductions.
Issues for LLC members with k-1s
LLC prop traders don’t have earned income reported on their Schedule K-1s, so they save SE tax but can’t contribute to a retirement plan or deduct self-employed health-insurance premiums. (One exception: A prop trading firm that trades futures as a full-scale member of a futures or options exchange per Section 1402i.) Trading gains on Schedule K-1 are considered net investment income (NII) under ACA NIT. (Read about ACA taxes in Chapter 15…
Prop trader expenses
Like retail traders, many prop traders have material trading-related expenses. The expenses charged by the firm to the trader are deducted at the firm level, and the K-1 ordinary income is already net of those expenses…LLC members are entitled to deduct unreimbursed partnership expenses (UPE), including home office expenses, on Schedule E. Independent contractors deduct business and home office expenses on Schedule C.
Writing off lost deposits
A fundamental tax issue prop traders face is when to write off deposits lost within the firm. If you incur a trading loss, the firm may take it on the owner/manager’s K-1, using your deposit to cover it…When fully lost, a prop trader can write off a deposit as a business bad debt.
For more information, seeGreen’s Trader Tax Guide, Chapter 12, Proprietary Trading.
