Jim Crimmins explains why becoming an S-corp may not be best for traders 

Generally, I’m bullish on business entities. Trading under a limited or general partnership, limited liability company or a C Corporation has so many tax advantages that going it alone as a sole proprietor ranks a far-distant second.

Unfortunately, some garden-variety accountants who are less familiar with the intricacies of our unique trader tax status continue to mistakenly recommend that you switch from a C Corporation to an S Corporation in order to avoid something called the personal holding company tax, or PHC.

What makes this downright odd is that traders by definition are not subject to the personal holding company tax regardless of their choice of corporate entity, as we’ll explain below.

At Traders Accounting, we don’t recommend S Corporations for most traders because the tax courts have ruled that you must take at least half of your profit in corporate payroll, at a 15.2% tax rate. Other entities such as LLCs and C Corps do not have this requirement.

It would be a shame if a trader went through the time and hassle of setting up an S Corporation only to find that all that effort was for naught!

Nevertheless, the personal holding company issue does warrant a closer look.

You Hold, You Lose

The PHC is a stiff penalty tax of 35% levied on C Corporations if 60% or more of their adjusted gross income qualifies as personal holding company income, such as dividends, interest and capital gains.

It’s that steep fine that continues to prompt some ill-informed accountants to recommend an S Corporation to their C Corporation traders.

But the operative word in the personal holding company tax is holding. Traders must meet strict IRS guidelines to obtain trader tax status, and one of the major ones is that you must seek to profit from the daily movements of the market and not from dividends, interest or capital appreciation.

In short, you hold, you lose – your trader tax status, that is. Put another way, by definition, most of a trader’s income cannot be personal holding company income. If it is, you will almost certainly not be considered a trader for long in the eyes of the IRS!

Entities Mean Business

The personal holding company kerfuffle aside, for most traders there is a compelling business case to be made for trading under a formal legal entity.

When you form a legal entity and choose the mark-to-market accounting method, you can convert personal expenses into deductible business expenses that can easily add up to $10,000-$20,000 annually. Should you experience substantial losses, you’ll be able to fully deduct those as ordinary losses as well, and not be restricted (as sole proprietors are) to the $3,000 capital gains cap.

While simpler “flow-through” entities such as partnerships and LLCs are appropriate for most traders, some traders like the perks, flexibility and stability that a C Corporation can provide.

As a solo C Corporation, you can:

• Protect your personal assets

• Take the maximum allowable business deductions, including 100% of your medical bills for health insurance, co-pays, deductibles, even many of the over-the-counter items you buy at the drug store

• Deduct $5,000 of your pre-existing start-up expenses and depreciate the remainder. Average Traders Accounting clients save $10,000 to $20,000 on this deduction alone.

• Establish a medical reimbursement plan, or MRP, under which you can deduct 100% of your medical insurance premiums, out-of-pocket expenses, deductibles and even uninsured health and accident expenses, and

• Shift income between the corporation and shareholders to minimize taxes.

Compared to sole proprietors, C Corporations also enjoy favorable tax rates: 15% on the first $50,000 of taxable income, 25% on the next $25,000 and a graduated scale between 34-38% thereafter. In addition, corporations face far less audit risk than sole proprietors.

Because a C Corporation is not a flow-through entity, it is taxed on its profits. If you receive dividends, you are taxed on them as well on your individual federal tax return.

To work around this potential double taxation, most solo and small C Corporations do not issue dividends, but instead pay only salaries and fringe benefits, which are then deductible to the corporation.

Granted, it takes a bit of extra organization, paperwork and compliance to establish and sustain a C Corporation. You must maintain separate books and records, hold and record annual meetings and issue stock to shareholders.

But for those who seek maximum flexibility in fringe benefits and health care options, a C Corporation offers many of the perks previously enjoyed only by large corporations.

Tax-efficient business planning starts from the ground up. Not sure which business entity is right for you? Contact Traders Accounting today. We can help you build the right platform for your business, now and into the future.

Cheers,

Jim Crimmins
Traders Accounting
TradeKing All-Star Commentator

Read Jim’s previous All-Star posts: For summer fun, visit Deductionland! and Key to Estimated Tax Payments? Pace Yourself!

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

The opinions expressed in this post are those of the author and do not necessarily reflect those of TradeKing. 

Jim Crimmins has a cross-marketing relationship with TradeKing.