• Travel to seminars, trade shows, and other business-related trips anywhere in the world
• Magazine subscriptions related to investing and trading
• Trips to look at corporations you are considering investing in
• The portion of your home expense that qualifies as a home business and a portion of all expenses paid on maintaining the property, utilities, etc.
• Automobile expenses
You can tell the list is rather inclusive and beneficial. Interestingly, as you begin to learn the nuances and combine all the advantages, they add up to a rather tidy sum.
HOW TO BECOME A TRADER
The IRS code does not define trade or business as it relates to the business of trading. The law that has developed comes from court cases and decisions made in the favor of taxpayers who have made this claim. The key elements in the cases were length of holding period, frequency of trades, and purpose for trading, that is, was the person’s intent to make money from dividend interest, long-term gain, or short-term trading?
If you are a currency trader, it is pretty easy to show your intent, since that is all you shoot for. If you also trade stocks, you can still make a claim for trader status even if you hold some of them long term, although it is doubtful you will anyway.
While we all hope our business, including our trading business, makes a ton of money, the reality is it won’t always do so. The good news is that if trading is a business, then your excess expenses can be used to offset income from other sources just like any other business would allow you to do. It is a win-win situation.
Let’s discuss using trader status as it relates to your personal tax return by creating a small sole proprietorship. In this case, you would place your ordinary business expenses on Schedule C, and you would report your income or loss on Schedule D, since it is still considered capital. No self-employment income is calculated on the income, and your trading losses are still limited to $3,000 per year but can be carried over indefinitely. You can also use any losses in the stock market to offset gains in the currency market.
Although the benefits of this strategy are good, there is another way, and often a better way, to operate the business. That is by incorporating the business and creating your own trade corporation.
A trade corporation is your new legal entity in which to conduct your trading. There are near-term advantages, longer-range asset protection, and family financial planning advantages. There will be some extra cost for setup and operation, but as you will quickly see, the advantages far outweigh the cost.
Your first advantage is clarity of purpose. If you form a corporation for the purpose of trading and conduct the trading in the separate entity, there will be no question regarding your trader status, nor will there be an issue about your personal tax return and the deductions you take. This is not to suggest that operating things in the sole proprietorship status is in the gray area of the tax code. It isn’t.
Some people like to keep their various businesses separate, protect assets from different creditors, and do estate and financial planning as they go. If you fall into this category of individuals, you should consider using a corporation as the entity to operate your trade business.
I have personally probably taken this to the extreme. It does cost a little more money to be extra careful, but to protect assets, I tend to open separate corporations for each separate business venture I am doing. This way I am not commingling assets, so to speak, among other companies. I primarily do this for the reduction of liability. That way if for some reason you do ever get sued, the lawsuit is basically relegated to the specific corporation in question. Starting a trading business is no different, since your assets in the trading company are not yours personally but the company’s.
WHAT KIND OF COMPANY
There are three types of corporations: C, Sub S, and LLC. A C corporation is considered a regular corporation. A Sub S corporation is so named because of the tax code section that gives it benefits. The LLC is structured to overcome some of the structural difficulties of the Sub S corporation. (Interestingly, about the time the individual states got through adopting massive legislation to get around the tax code, Congress decided it didn’t want to be outdone and amended most, but not all, of the difficult portions of the Sub S code.)
To be fair to both you as the reader and me as the author, I must now disclose that I am going to make sweeping generalities about which corporations are best and why. The problem is everyone’s circumstances are different and volumes have been written about the “best” structure to use. Nevertheless, we will attempt to weed through the tangle of red tape to uncover some solid ideas.
The C corporation is primarily used for public companies, multiple shareholders who aren’t interested in distributing profits and losses, but want to build an entity and individual businesses that benefit from a medical reimbursement plan or some types of retirement programs.
For some people, the medical reimbursement can be a great deal because under the current law, individuals and joint filers are limited to medical deductions after a 2 percent limitation of adjusted gross income.
Excepting the medical situation, you will likely benefit greatest in either a Sub S corporation or an LLC. The reason is that both have tax flow benefits at the shareholder level. This means the corporation doesn’t pay a separate tax, but the shareholders (in the Sub S) and the members (in the LLC) pay tax on any gain or take losses personally if there are any. This gives you the benefit of a personal tax shelter in years where there is a loss in the company.
It should be noted that if you are going to be the only share holder of your company, then the Sub S corporation is probably the one you should consider. Being a single-member LLC has its complications. The IRS will basically consider you a sole proprietorship if you have an LLC and you are a single member, meaning that you are the only owner. If this is the case, then you will basically be giving up the corporate benefits that you are looking for. So look to the Sub S to provide the corporate flexibility you need.
The benefit to using a Sub S is that it has been around the longest, and so most CPAs and attorneys are comfortable with it. The benefit of the LLC is that you can do some interesting family, estate, and asset protection planning.
Let’s take a look at a few examples. Let’s say you form an LLC trade corporation. In an LLC, you are allowed to issue multiple types of shares. Because you would like to shift some of your trade income to your children, you issue them a preferred class of stock that has no voting rights but has a preference of income up to a certain level.
This “income-shift” strategy allows you to maintain 100 percent control of your company and all the assets, but shifts dollars to your children, who are in a lower income bracket than you. The children can use the money to pay their bills.
Another twist on this strategy is to pay your children a salary out of the corporation for work they do. The work, depending on age and ability, would give them earned income and allow them to set up an IRA or other retirement program at an early age. While income shifting takes money out of your pocket and puts it in someone else’s, you get the deduction; and if you can control what happens to the money, it is the same as having it. Another benefit to helping your children grow an early retirement program is that you may at least have someone to support you if things don’t always go as you would like.
LLCs have another advantage; they can be used to protect assets. If you find yourself in a situation where you need to be protected, you can put your assets in an LLC and give, sell, or otherwise structure the share ownership in someone else’s name. You can continue to draw a salary from the company and control the operation of the company through special shares, which can be drafted to give you specific rights to do so.
The assets now belong to someone else and are no longer attachable by the creditor, and the income you receive is not attachable because it is a salary. (Some states give certain creditors rights to lien a portion of salary, but this can be adjusted to fit the situation.) Please note, in this example you have actually given up these shares and the assets they represent. This can be a shame. On the other hand, without that happening, you would have lost the assets to a creditor not of your choosing.
By using this structure, you at least shifted the asset to someone you know, and you get income generated from the company in the form of a salary. I would also like to point out that there are laws governing fraud on creditors. These laws do not prevent you from properly protecting yourself and your family, but they are intended to stop what are called shame transactions, where there is no truth or substance to your actions. Since we are only talking about proper planning, these and other strategies should all be available to you and used when needed.
Now let’s talk about one other method for setting up a business, but in this case we will talk about setting up an offshore business. You hear about it all the time, about people setting up offshore businesses. It is certainly more expensive, but it is also much more secure for liability protection.
A lot of people have set up offshore businesses to protect their profits by paying less in taxes and so forth. Well, this is not why I would recommend setting up an offshore business. I would primarily recommend that one consider setting up an offshore business for asset protection and/or liability protection. The simple fact of the matter is that if you make money, you should pay taxes. Not more than your fair share, but you should certainly be paying your taxes. Furthermore, the IRS is not stupid, so you can be sure that if you think you can get away with not paying your taxes, think again.
Okay, with that said, let’s look at some specific examples of setting up offshore corporations and protecting your assets. The best place to set up an offshore corporation is in a country that is still under the Commonwealth (formally known as the Commonwealth of Nations and what used to be called the British Commonwealth). The laws are much more beneficial to your corporation.
Some of the more proactive places to set up an offshore corporation would be Belize, Panama, Seychelles, Cook Islands, Cayman Islands, and British Virgin Islands. There are others, such as up-and-coming Dubai in the UAE, but they are more expensive and a little harder to set up in than some of the other ones I have listed.
The cost to set up one of these offshore companies is a little more than what it would cost in the United States. In the United States, you can easily set up a company for about $150 to $300; for an offshore corporation, you will pay $2,000 to $10,000. If you want to open a U.S. corporation or a foreign corporation or trust, you can go to www.jdfn.com, which offers detailed information and help in finding the right company to assist you. There is also a link to a law firm that I use that can set up a U.S. corporation in any state you want.
So for liability’s sake, let’s say you open a company in Belize, and to better protect yourself, you create an offshore trust in the Bahamas. You would have the offshore trust own the company in Belize. You would make the beneficiary of the trust someone other than you, maybe a trust you have in the United States has the ownership. You then can be a director of the corporation and open a bank account on its behalf. But if you want to take the liability one step further, you can open your bank account in, say, the British Virgin Islands.
Now keep in mind that if you are a U.S. citizen and you open a bank account in another country, you will have to file the appropriate forms with the IRS, letting the agency know that you have a foreign bank account that you control. Also for tax purposes, if you own a foreign corporation and you are the majority owner of that company, the IRS considers the foreign corporation to be a closely held corporation and will tax the foreign corporation as it would any of your other assets. There may be some additional taxes that go along with that as well. You should talk to your CPA before taking this much more aggressive approach to protecting your assets.
In the example above, we actually don’t have any ownership of the company, since we have a trust in the Bahamas that owns the company and we are not the beneficiary of the trust. However, in this example I would still claim the company as closely held, since I didn’t set the company up for tax reasons but for liability reasons.
If for some reason someone wants to sue the company, he or she is going to have to sue a company that is domiciled in Belize, that is owned by a trust in the Bahamas, and that has a bank account in the British Virgin Islands. Good luck with that one. But, again, if you’re making lots of money and your trading business is really doing well, you may want to consider protecting your hard-earned dollars from unscrupulous attorneys and frivolous lawsuits.