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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 2012 Trader Tax Guide • Copyright © 2012

For more information our proprietary trading, see our separate Proprietary Trading section.