In This Chapter

The assumption of this book is that you plan to pursue active trading as a full-time career. You can certainly take some of the information from here and other sources to dabble at it part-time, but most active traders want to go full-time as soon as possible. Active trading, as we have seen, encompasses several strategies. The most intense strategies and those with the most promise for supporting you and your family require a full-time commitment.

You should start your active trading career the same way you would start a business—with legal and tax advisers on hand to make sure there are no missteps. Your biggest concern is going to be taxes and accounting for your income (and losses) and expenses to the satisfaction of the IRS. You are safer if you know what the requirements are from day one rather than learn too late that you have run afoul of the tax code. The IRS does not count “I didn’t know” as a valid excuse. Get your mind set that this is a business and run your trading operation like one.

If you make all or most of your income from trading, you should seriously consider organizing yourself from a legal and tax perspective as a business. The best strategy is to do this from day one, with the help and guidance of competent legal and tax counsel. It is important, especially of your tax adviser, that your counselors have experience with the intricacies of trading as a business. As we’ll see below, there are special considerations for securities traders by the tax code, but, as always, you must meet certain tests.

Your accounting system should capture the information necessary to satisfy tax code requirements for the most favorable treatment. If you are a short-term trader making dozens of trades each day, your accounting system must be robust enough to handle the profits, losses, and expenses of each trade. Your broker may provide this information, but ultimately you are responsible for its accuracy and reporting it correctly to the IRS. Homemade systems from scraps of paper won’t get the job done.

You may want to consider incorporating yourself for legal and tax reasons. Whether this makes any sense for you is a decision that you will have to make with your tax and legal advisers. However, there may some advantages to a legal structure beyond a sole proprietorship.

As we dive into everyone’s favorite subject—taxes—let’s get one thing very clear. You may call yourself a trader and your spouse may call you a trader (or traitor, but that’s another story), but until the IRS declares you a trader, you aren’t one for tax purposes. Like most other issues with the IRS, there are certain tests you must meet to be declared a trader. You definitely want this designation because it means you are eligible for certain deductions not available to others.

The IRS says you are a trader if:

A good tax adviser with experience in this area can tell you what will stand up under an IRS audit. You want to be nowhere near the edge on this one. A ruling against you in this area will cost you dearly in deductions the IRS will not allow, which means a big tax bill.

You can find several different types of tax advisers in most phone books, but for this type of reading of the IRS code, you should only consider the most qualified. That means a Certified Public Accountant (CPA). Some CPAs specialize in tax work and advice. You will pay more to use a CPA than some of the other designations, but your business will be set up correctly and you should not have to worry about the trader designation (assuming you meet the qualifications).

If the IRS says you must have thousands (3,000 is considered a good number, but that is subject to change and interpretation) of trades each year to qualify as a trader, they all must be recorded for tax purposes. Unfortunately, it is not just a simple matter of putting winners in this stack and losers in another stack. The IRS has special rules that will make you crazy if you don’t follow them carefully.

Traders don’t have earned income the same as people with regular jobs. Earned income is a salary, commissions, and such. Traders live in the world of capital gains and losses.

Along with some special rules for traders, capital gains and losses require special attention, not just at tax time, but also as part of your trading strategy.

When a trader sells a security for a profit that is a capital gain. As you might guess, if the sale is for a loss, it is a capital loss. The fun doesn’t stop there, however. If the trader held the security for less than one year, which will be most of the time, the capital gain or loss is considered short term. If the security was held for more than one year, it is a long-term gain or loss. The time designation is important because long-term capital gains (as of this writing) are taxed at a much lower rate—15 percent—than short-term gains. Short-term gains are taxed as ordinary income, which could be much higher.

Most traders deal in short-term gains, so it is extremely important to take advantage of any help the tax code gives you. Some gains can be offset by losses, but the rules are complicated and here is where your tax adviser will earn his fees.

One of the biggest headaches for short-term traders is the wash-sale rule. The rule says you can’t deduct a loss if you also have a gain in the same or substantially similar security within a 61-day period. What does this mean? Many short-term traders will buy and sell the same security several times during a trading day and may do this day after day. The wash-sale rule has the effect in many cases of not allowing any of the trader’s losses in those trades to be deducted from her taxes.

You are allowed to add the loss to your basis of the stock, which may end up giving you a deduction in the long run. However, this is a complicated rule that requires precise record-keeping to justify.

If you qualify as a trader, there are some things you can do to offset the negative impact of the wash-sale rule. Whatever your strategy, it requires comprehensive record keeping or the IRS will chuckle while making out your tax bill.

If you meet the IRS’s definition of a trader, you are eligible to request a change in accounting methods that will save you money and hassles with the wash-sale rule. The catch is you can’t use it the first year you’re a trader. You must complete a year as a trader and submit the request form with your tax form for the year. If approved, you will be allowed to use the mark-to-market election when figuring your capital gains and losses.

This election, if allowed, lets you forget about the wash-sale rule. You convert all your capital gains and losses to income. For active traders, this is probably not a big deal since they are unlikely to hold a position open more than one year anyway. By giving up any chance for a long-term capital gain, you get to forget about the wash-sale rule. Your paperwork is greatly reduced and most traders will see a reduction in taxes.

Your tax adviser can explain the finer points of mark-to-market accounting and what it means in terms of bookkeeping and so on.

In addition to tax benefits, this election also allows you a greater deduction of business expenses. Those expenses are important deductions when it comes time to do your taxes. Be sure you document all of the expenses directly related to your trading business. You can do this in a journal or better still through a software program such as QuickBooks.

If you decide to adopt a formal business structure (partnership or incorporation), there may be other considerations—your legal and tax advisers will help you there.

Following are some of the major expense categories you can deduct.

Most active traders work out of their home. If you do, you can claim a deduction for dedicated space to your trading business. Ask your tax adviser how to do this. If you rent space in a commercial business, the process is somewhat more straightforward as long as you don’t run any other businesses out of the same space.

You can deduct related office supplies and equipment up to an amount set each year by the IRS. This includes furnishings, computers, and so on. There is a limit to how much you can deduct, so don’t go crazy. Remember, deductions are not dollar-for-dollar reductions in your tax bill, but at your prevailing tax rate. If your tax rate is 28 percent and you spend $1,000, you get to deduct $280 from your taxes. You will need receipts to prove you actually spent the money.

Most consulting fees associated with your trading such as accounting and legal services are deductible. If you use a bookkeeper or other services directly related to trading income, those are probably deductible, also.

You can deduct interest you pay on margin loans. It may not be much for most traders, but interest paid on loans for trading is a deductible business expense.

The IRS says you can’t deduct commissions on trades, which many traders simply can’t understand. Isn’t that a cost of doing business, just like a telephone or computer? Actually, you do get to deduct commissions, just not in a straightforward manner.

The IRS allows you to add commissions to the cost and deduct them from the sale. This has the effect of reducing the amount of tax you owe, while avoiding any limits deductions.

The IRS also says attending investments seminars and annual meetings are not deductible. The reason is both usually involve travel and could easily become ways for taxpayers to subsidize vacations. Imagine how many investment seminars would pop up in vacation resorts if the expenses were tax deductible?

The IRS also notes that it will not allow tons of deductions for a hobby that loses money year after year. If you lose money three out of five years, the IRS will probably revoke your most favored trader qualification and you will lose the accounting and expense deduction benefits.

Tax laws are complex and change frequently. Nothing in this chapter should be read as a definitive interpretation of tax code. Please use the services of a qualified tax professional, preferably a CPA, before making any tax decisions.

How you decide to organize your trading business depends on several factors. That decision should come after a conversation with your tax and legal advisers to consider all the benefits and pitfalls. Ideally, the entire team would be in the same room so each option could be discussed and evaluated. You will make the final decision; however, it should be made with a full understanding of the consequences. The greatest impact will be on your potential tax liability, because it’s safe to assume your attorney would not let you do something that is illegal.

As we have already seen, those tax consequences can have a real effect on your trading policy, which can alter basic profitability assumptions.

There are a few minor rules and regulations that you should pay attention to as you are getting your office organized and located. Many active traders work from home, as noted previously. Unfortunately, many homes are not up for hosting a business. Often a spare bedroom or a room in the attic or basement becomes command central for the trader. We’ll talk about outfitting your office in Chapter 22, but before we get to that point, we need to do some legal work. You may be able to do some of this yourself or have your attorney do it for you.

The popularity of home businesses has led some communities to enact zoning laws covering what you can and can’t do from your home. In some cases, communities have enacted very strict zoning laws to prohibit home-based businesses that have an unusual number of shipments or deliveries. Other communities have restricted the number of employees a home-based business can have. Other ordinances require fire inspections and other commercial inspections. Along with these additional services will come additional fees, licenses, and other ways of parting you with your money.

Most active traders work alone, so many of the activities that regulators fear (customers, deliveries, employees creating traffic problems) aren’t going to happen. However, if your local government requires you to get a permit or license of some type, don’t think you can ignore it. Violations can result in fines and even shutting down your operations. If you’re having a hard time getting answers from the local authorities, check with the Chamber of Commerce for information on starting a business.

As we noted above, the choice of legal structure is a matter you should discuss with your attorney and tax adviser. There are advantages for some traders in formalizing their structure, but there are also additional costs and paperwork to go along with it. Weigh the costs and benefits to see what is best for your situation, but rely on advice from your attorney and accountant, not generic pronouncements you may read on the Internet.

Many traders don’t choose a formal structure for their business, which means by default they are sole proprietors. Being a sole proprietor simply means you are the business and the business is you. There is no stock issued and no legal papers to file in many cases beyond any business permits or licenses your local or state government may require. Any income or loss from your trading goes on your personal income tax form along with any special forms your tax adviser provides.

The sole proprietor has the big advantage of simplicity. Beyond business licenses or fees, if any, there is usually nothing to do. If you want to give your trading business a name and have a separate checking account—which is a good idea—you may need to file an assumed name with your county clerk or other local authority. This is usually a simple matter of going to the courthouse, filling out a form, and paying a small fee.

The assumed name filing tells the public that you are doing business under a name other than your own. Many banks will not open an account under a fictitious name without a certified copy of the assumed name certificate. Once you have this done, you can get business cards and so on printed with your company name.

The sole proprietor is also the easiest form of business to quit. You simply close the checking account and pay off any outstanding bills and you’re done.

The downside of the sole proprietorship is that it offers no protection at all from creditors or anyone who wants to sue you. If you don’t pay your bill at the broker, they will come after you regardless of whether you have an assumed name or not.

Be sure to keep business expenses separate from personal expenses. This will make it easier and cleaner at tax time.

A partnership, which is the next step up in legal organizations, doesn’t make much sense for an active trader unless you are going to form some type of trading group to pool expenses. This is a real possibility for some traders who want to share facilities with other traders, but run their own trading activity. Partners can share office, equipment, and service expenses, which might allow each trader more resources than would be practical for them to own alone.

An attorney needs to draw up the partnership agreement to make certain that all aspects of the relationship are covered. How will decisions be made? What happens when a partner wants to leave? How are partnership assets valued? All of these questions and many more should be addressed in the partnership agreement.

Don’t assume because you have known the future partners for years that you will be able to work things out without spelling everything out in writing. That’s a good way to destroy a partnership and lose friends.

The concept will work, but it requires a complete, written understanding of every detail and a plan for every circumstance to be successful. Generally, profits and losses to the partnership flow through to the individual members.

If you think you want to incorporate, there are several possibilities. However, the benefits of incorporating for the active trader are limited compared to most businesses. When you incorporate your trading business, it becomes a separate legal entity from you. This has some benefits and drawbacks. For one thing, the corporate tax rate may, in some cases, be lower than individual tax rates. If you incorporate your trading business, you can become an employee of the business who draws a salary, has benefits paid for by the corporation, and a retirement plan jointly funded by the company. You don’t pay self-employment taxes.

Is this a better situation than being a sole proprietor? Only your tax adviser can answer that question. However, forming a corporation is more expensive and does require filing two tax returns (yours and the corporation’s). The corporation may be able to take some expense deductions that you can’t as an individual. The corporation can hire your children to do legitimate work and pay them a market rate for that work, while writing off the expense. Don’t do anything your tax adviser doesn’t approve of, but these are legitimate benefits.

How you organize your trading business is a decision that will make itself after you talk it over with your tax and legal advisers. The bigger issue beyond that is how you think about your active trading business. If you approach it with the mindset that you are running a business that has profit goals, expense concerns, and a business plan, it will help you be a better trader. We’ll discuss this process in more detail in the following chapters.

The Least You Need to Know