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Proprietary Trading
Proprietary traders have special tax preparation needs too. They are
significantly different from retail traders. Proprietary traders don’t
trade their own capital. They trade the proprietary trading firm’s
capital, usually accessed from a subtrading account within the firm dedicated
to a particular prop trader. A prop trader becomes associated with a prop
trading firm either as an LLC member (limited ownership, receiving a Schedule
K-1) — the preferred method by regulators — an independent
contractor (1099-Misc) or as employee (W-2).
PROP TRADING TAX MATTERS
Profitable independent contractor (IC) proprietary traders receive a 1099-Misc.
for “non-employee compensation.” If they are a sole proprietor,
they use a Schedule C to report fee revenue and deduct their business
expenses, including home-office deductions if they qualify for one. While
many trade from a prop trading firm office, they qualify for a home-office
deduction too. Schedule C net income is subject to federal and state income
taxes.
Firms don’t issue 1099s to losing IC traders, since they don’t
pay them fees. Losing IC traders are still working, so they’re entitled
to file a Schedule C, which will report expenses only. It will be a red
flag to the IRS, so consider consulting with a trader tax expert about
it first.
TAXES AND LEGAL ISSUES FOR LLC MEMBERS WITH K-1S
LLC member proprietary traders don’t have earned income reported
on their Schedule K-1s, so they save SE tax but can’t contribute
to a retirement plan or deduct health-insurance premiums.
A few prop trading firms allow LLC member traders to form a 100-percent
owned entity and then the trader can create some earned income. That may
be the only way to get those valuable AGI deductions.
PROP TRADERS’ EXPENSES
Like retail traders, many prop traders have significant trading-related
expenses. The expenses charged by the firm to the trader are deducted
at the firm level and the K-1 line one ordinary income is already net
of those expenses. The trader isn’t reporting those expenses separately
on their individual tax return.
Some prop trading firms have an “Accountable Reimbursement Plan”
and the prop trader needs to “use it or lose it” before year
end. If your firm doesn’t have such a plan, then you can deduct
your own trading business expenses outside of the firm, including your
home office as Unreimbursed Partnership Expenses (UPE).
WRITING OFF LOST DEPOSITS
A key tax issue for all types of prop traders is how and when to write
off deposits lost within the firm. If you incur a trading loss, the firm
may take the loss on the owner/managers’ K-1, but it will use your
deposit to cover it.
For an IC trader, the lost deposit is not reflected on the annual Form
1099-Misc. When the deposit loss is realized, the IC trader can deduct
a business bad debt on Schedule C, as another ordinary and necessary trade
or business expense.
If an LLC member prop trader has a lost deposit, he deducts the deposit
as UPE on Schedule E.
This is an excerpt from Green’s
2013 Trader Tax Guide • Copyright © 2013
For more information our proprietary trading, see our separate Proprietary
Trading section.
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