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Is Trading Your Business? Making it Official for Tax Purposes

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January 3, 2013
Is Trading Your Business?

Hey you, titan of the home office. Are you trading so often these days you’ll spend minutes readjusting your monitor or your chair a millimeter at a time to get it just right?

If you’re detailed when it comes to seats and screens, you should care equally about tax details. Only serious traders need apply. But for those who qualify, paperwork pain now might pay off later. That’s because if you trade as a business, rather than as an individual investor, you might realize important tax advantages.

Sure, setting up a separate entity, and keeping up with the bookkeeping and regular filing required by the IRS, takes time and money. But, once established, you’ll get tax breaks on items you buy anyway. Think software, skills courses, office furniture, and gadgets—trading-related expenses you can legally deduct. In some cases, you can expense the cost of health insurance, too.

There’s more. Trading as a business entity allows qualifying traders to avoid the wash-sale rule. Instead, elect Section 475, which uses mark-to-market accounting. Stay with us. We’ll explain.

A wash sale occurs when an investor purchases a stock within 30 days prior, or 30 days after they sell the same (or very similar) position at a loss. According to the rule, the investor cannot record a capital loss on the trade if the same position is bought again within 30 days. Therefore, if tax time is approaching, and you want to sell that losing stock position for a tax benefit, the wash-sale rule prevents you from buying it back within 30 days as an individual investor.

Electing Section 475 within a trading business changes your accounting methodology to mark-to-market. With this approach, when taxes are prepared, all open positions are treated as if they were closed on December 31. You don’t need to sell or liquidate anything in order to record a capital loss on losing positions. In addition, Section 475 allows traders to book losses greater than $3,000 per year, and carry some losses over to future filing periods. Consult your tax guru or the IRS site for more information. Keep in mind: you must elect Section 475 when you establish your business taxfiling status, not at filing time.

The simplest way to transition from an individual investor to a trading business is to set up a sole proprietorship, or limited liability company (LLC). This status hinges on your ability to demonstrate “regular, frequent, and continuous” trading, according to IRS rules. Alternatively, a trader can set up a business by incorporating under “Subchapter S,” or other corporate entities. Consult irs.gov for details on more complex filing status options, and to determine eligibility.

Mulling whether to go pro? Here’s a side-by-side comparison:

Get Down To Business

INDIVIDUAL BUSINESS
Can deduct a maximum of $3,000 per year in trading losses Can deduct more than $3,000 per year in capital losses, if using mark-to-market (Section 475 election)
No deduction for health insurance expenses and cannot contribute to a retirement account (unless through an IRA) Can contribute to retirement accounts, and deduct health-insurance premiums
Limited deductions for business expenses, related to other earned income Deductions often allowed for trading expenses like computers, seminars, subscriptions, and use of home office
Bound by wash-sale rule; cannot book a loss on equities bought back within 30 days of sale Can elect Section 475 (mark-to-market), and book end-of-year losses on equities without selling them

FIGURE 1: Trading as a business might offer distinct tax advantages for investors who qualify. Consider the differences between trading as a business, versus as an individual.

Tax Prep

For important upcoming dates, visit the Tax Document Calendar at the Tax Center. Log in to your account at tdameritrade.com, and go to: Accounts > Tax Center > Tax Document Calendar.

The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.

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