Sole proprietorships and individuals are trading like corporations; daily traders make a living this way. These people can face significant tax liability, depending on how successful they are. Sole proprietorships and individuals who trade can face substantial tax liability. They have several options: They can become a corporation, qualify for trader status, or incorporate as an S corp. These traders want a legal business entity to operate more efficiently and benefit from some tax advantages available to corporations.
Want to know how to incorporate a business in the U.S. and avail of those benefits? Keep reading to learn more!
What a Trader’s Tax Treatment Is Like
Per the Internal Revenue Service (IRS), trading is not a business activity. After all, the IRS assumes all individuals are investors, and trading for short-term capital gains is considered a passive activity. Conversely, long-term capital gains are earned by individuals who wish to accumulate funds for retirement.
These individuals generally do not have any additional tax burdens because income from trading cannot be reduced by contributing to individual retirement accounts (IRAs) or pension plans. The only benefit of being considered a passive trader is that income derived from trading is not subject to self-employment taxes.
Other than that, deductions are the same as what is typically afforded to W-2 wage earners (generally limited to mortgage interest and property taxes). The amounts of most deductions are restricted to a percentage of adjusted gross income.
Finally, because trading is not considered a business activity by the IRS, all expenses necessary to trade are not eligible for tax deductions. For most active traders, the costs of necessities–such as education, a trading platform, software, internet access, computers, fees, etc.–can be considerable.
Traders will likely face their biggest tax issue regarding their losses. Only $3,000 can be deducted against ordinary income for losses over gains in a given year; anything above that amount must be carried forward until an income year when the loss is lower than $3,000. Those costs alone make it more appealing to follow through with the question “How to incorporate a business in the U.S.?”
A Trader’s Tax Remedies
Because active traders (i.e., people who trade for a living) are eligible for capital gains treatment, they have become more dependent on specific strategies. To qualify as a “trader,” an individual must spend more than half of the year actively trading, and they must also meet either the “holding period” test or the “substantially identical” test.
Under both tests, individuals must either:
- spend more than half of their time buying and selling securities in the same company or
- conduct at least three trades in at least two different securities in a given year.
If they pass both tests, they can file Schedule C and deduct all their trading-related expenditures. This could include education, entertainment, margin interest, and other trading expenses. They can also take a Section 179 deduction for equipment used in their trading activities.
Finally, traders can also use mark-to-market (MTM) accounting instead of the standard method for valuing securities transactions. Under MTM accounting, capital gains and losses are regarded as ordinary income, though the capital losses are deductible in the year they occur. By avoiding capital gains treatment for active traders, the IRS is essentially trying to capture more revenue from these taxpayers.
In the End, It’s Better to Incorporate
With tax fines going as high as $25,000 in late fees or incorrect filings, it’s better to register and incorporate oneself as a legitimate trader. It eliminates the hassle of costly mistakes while also empowering individuals to partake in their benefits, most especially the Schedule C and Section 179 deductions.
Speak to the experts at Doola today to know how to incorporate a business in the U.S.! We’re a trusted partner for global entrepreneurs that helps them incorporate, access U.S. payment systems, and stay legal year after year through continued support, business basics, and a global-first mindset. Book your free tax consultation call now!