Special thanks to our guest commentator, Steve Ribble on the following guest post on trading and taxes. Please enjoy the following educational post and be sure to speak with a tax professional before making any decisions.
Trading as a Sole Proprietor
The simplest business structure for someone whose activity rises to a level that they qualify for trader status is as a sole proprietor. This is just another way of saying that you are the owner of a one person business. Sole proprietor is the least expensive and easiest of all the business types, making it a popular choice among traders. There is almost no cost or bureaucratic hoops to jump through to get started. You don't even need to do anything to create one. If you start a one person trading business and do not form a corporation or LLC, you've started a sole proprietorship and that is how the IRS and your home state will treat your business.
Most sole proprietors will need to register for a business license & permit (if required for your business) and potentially other regulatory requirements that your state and/or local government imposes on any business, but traders do not have these requirements. Since they deal only with their own money, there is no need for a business license or permit. There is formal notice to notify the IRS, and you have no annual filing requirements to operate a sole proprietorship.
By definition, a sole proprietorship has only one owner. If you wish to include other owners, you will need to choose a different business structure, such as a partnership, LLC, or corporation.
John is a computer programmer who started trading part time out of a home office. Since his activity has risen to a level to categorize him as a trader in securities, he is automatically classified as a sole proprietor. John does not need to file any legal paperwork. His business is automatically classified and treated as a sole proprietorship in the eyes of the IRS and his state government.
LIABILITY FOR BUSINESS DEBTS
One of the biggest drawbacks to operating as a sole proprietor is the risk involved. That is because sole proprietors are 100% personally liable for all business debts and legal claims. For example, if someone has an accident in the sole proprietor's business and then sues, the owner is responsible for paying any resulting court award. 100% personal liability means that the owner's personal assets, such as bank accounts, equity in a house or car, and other personal assets can be taken by court order and sold to repay business debts and judgements.
Keep in mind that some businesses are much more vulnerable to debts and lawsuits than others. If you are trading only for yourself, your business is unlikely to be sued so you probably don't need to worry about these issues.
Sole proprietor traders report their business expenses on IRS Schedule C, Profit or Loss From Business (Sole Proprietorship), which gets filed with their personal Federal Form 1040. The income or loss (capital gain or capital loss) is reported separately on Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses.
Sole proprietor traders DO NOT pay Social Security and Medicare taxes on their trading gains. Most sole proprietors must pay self employment taxes on earned income by preparing Schedule SE, the Self Employment Tax return, which gets filed along with the Schedule C and Federal 1040 income tax return each year. However, since trading gains are classified as unearned income, traders do not file Schedule SE.
This brings up an important point about sole proprietor traders: the ability to generate earned income. Since trading gains are classified as unearned income, sole proprietor traders run into a problem if they want to deduct healthcare expenses or contribute to a retirement plan. You need earned income in order to do these things. Without earned income, the healthcare expenses get deducted on a Schedule A, where you loose a big part of the deduction (subject to a 10% of adjusted gross income floor).
If you happen to be married, earned income can be created by paying a spouse to work for you in your trading business. This opens up healthcare deductions and retirement plan contributions. However, sole proprietor traders who are single do not have this option. If you fall into this category, you need to establish a single member LLC or S-corp and pay yourself a salary to generate earned income.
Most traders start out trading as sole proprietors. For a lot of traders, this structure works just fine. A sole proprietorship is very inexpensive to set up and maintain, and requires very little to operate it. However, if are a profitable trader needing more deductions (healthcare and retirement plans), you might consider an LLC or S-Corporation for your trading business.
If you have questions on which type of business entity is right for your trading business, I offer a free consultation to discuss your particular situation. Email me at info@ShrinkMyTaxes.com for more information.