PROPRIETARY TRADING

PROPRIETARY TRADING
RESOURCES

GTT resources for proprietary trading firms:

Check out the July 2002 cover story on proprietary trading in Active Trader magazine. "Choosing sides: New traders are faced with numerous choices, but one of the first might be the most difficult. Deciding whether to trade through a proprietary firm or a retail brokerage is not easy — there are advantages and disadvantages to both and many issues to weigh. Read on to learn more about what to take into account before making a choice." The story was written by JEFF PONCZAK. To read the article, click here. Jeff refers to tax matters on proprietary trading written about by our Robert A. Green, CPA, in the Business of Trading section in Active Trader magazine. Click here for a list of those articles.

See List of Proprietary Trading Firms. Click here.

Testimonial from a trader who read this page and "saved himself" with this information. Click here.

Message boards where GTT has offered advice on proprietary trading:
Our Robert A. Green, CPA, is active at the www.EliteTrader.com boards. He is answering many questions on proprietary trading. Here are some of those questions and answers organized by topic.

Self-employment taxes

Trading remotely from Nevada with an LLC prop firm

What happens if a trader deposits $25,000 into an LLC and loses it all during the year?

Self-Employment Taxes:

The question was posed: "Greentradertax, are traders receiving K-1s exempt from social security taxes?"

Answer: Our position is that prop traders are exempt from self-employment (SE) taxes on trading gains reported on their Form K-1s. Trading gains are sometimes reported as "ordinary income" since they are subject to mark-to-market accounting (MTM). Therefore, they are "ordinary."

In general, an LLC member (partner) is subject to SE taxes on partnership income. Only limited partners in certain circumstances can avoid SE taxes.

Class A LLC members of a broker/dealer firm (i.e., the owners) make considerable income from commissions, so they are subject to SE taxes on their K-1 income.

Our position is that if a proprietary trader's only income from the LLC prop trading firm is their net share of trading gains from their "sub-trading" account (after expenses and other charges are applied) and they don't share in any firm-wide "earned income" activities, that trader is exempt from SE taxes. We based this position on the overriding tax law that trading income is exempt from SE taxes.

Our position is also predicated on the tax theory that a partner's K-1 reports their "piece" of a partnership "pie"; in these cases, the partner's piece only has trading activity and no "earned income" activity.

Note of caution: This tax treatment is not specifically addressed in the tax code, and it is only our informed interpretation. Each trader's facts and circumstances may vary within a given firm or among firms. Before you decide not to pay SE taxes on your K-1 income from an LLC, you probably should consult with a proven trader tax professional. We can help, but so can other experts.

Here is the general tax law:

The general rules for LLCs vs. S-Corps are as follows: LLC members pay self-employment tax on the net income of an LLC, which is passed through to its members. S-corporations pay one-half of the employment tax for their shareholder-employees, and the shareholder-employees pay the other half. However, the tax code does not impose employment tax on the net income a S-corporation passes through to shareholders (other than wages).

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RIA information:

“Net earnings from self-employment” defined.
With modifications described below, the term “net earnings from self-employment,” for purposes of the self-employment tax, means the sum of these two amounts:

(1) The gross income of an individual derived from that individual's trade or business, less the deductions permitted by the Code that are attributable to that trade or business. 14 “Trade or business” for self-employment tax purposes has the same meaning as when used for federal income tax purposes in allowing trade or business expenditures under Code Sec. 162 . 15 For activities included or excluded from a trade or business for self-employment tax purposes,

(2) The individual's distributive share of income or loss (whether or not distributed) from partnerships in which the individual is a member.

Code Sec. 1402(a) ; Reg § 1.1402(a)-1(a)(2) .
In computing gross income and deductions under (1) and (2), above, modifications are required to arrive at net earnings to which the self-employed tax rate is applied. Income modifications consist of (a) excluded income items, and (b) included income items,

Special modifications apply in determining net earnings from self-employment of:

... Partners (see below)

For purposes of the self-employment tax, net earnings from self-employment include an individual's distributive share of income or loss from a trade or business (whether or not distributed) carried on by a partnership of which the individual is a member.

Code Sec. 1402(a) .
A partner includes in self-employment earnings his or her share of the partnership income or loss, as separately stated on the partnership return, which arises from the trade or business of the partnership. Thus, in computing self-employment earnings, a general partner could take into account current passive losses from his partnership's farming activity.

Self-employment income is reported to the partner on the Schedule K-1 (Form 1065) the partner gets from the partnership. If income from some source unrelated to the business is included in the share, it should be eliminated.

RIA observation: The application of the self-employment tax to the income of partners results in the partners being subject to self-employment tax on income generated by their services as well as income generated by the partnership capital. Where partners cannot avoid the self-employment tax under the limited partner exception (see below), it may make sense to segregate the capital intensive business from the service business. For instance, a group of doctors who conduct a radiology practice as a partnership may place the ownership of the x-ray equipment in a separate S corporation that would charge the partnership for the use of the equipment. Thus, while the income from the doctors' services would be subject to self-employment tax, the income generated by the use of the equipment wouldn't be subject to self-employment tax.

A partner picks up the distributive share of the partnership business earnings regardless of the partner's lack of active participation in the business. 26 But for an exception applicable to limited partners,

When the partner's year is different from the partnership's, the partner picks up the distributive share of the partnership earnings for the tax year of the partnership which ends with or within the partner's own tax year.

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Self-employment income of limited partners.

In computing net earnings from self-employment, the distributive share of an item of income or loss of a limited partner is excluded. But this exclusion doesn't apply to guaranteed payments ( ¶ 576,055 ) to that partner for services actually rendered to or on behalf of the partnership, to the extent the payments are shown to be remuneration for those services. 34 Thus, these payments would be included: salary and professional fees received for services actually performed by the limited partner for the partnership. If a person is both a limited partner and a general partner in the same partnership, the distributive share received as a general partner is covered under social security.

Under proposed regs, a partner's net earnings from self–employment would not include his distributive share of income or loss as a limited partner (defined at ¶ 576,058 ). However, guaranteed payments made to the partner for services actually rendered to or on behalf of the partnership engaged in a trade or business would be included in the partner's net earnings from self–employment. 35.1 The proposed regs would apply for the first tax year beginning on or after the date the proposed regs are published as final in the Federal Register.

RIA recommendation: Taxpayers who want to exempt their partnership's distributive share from the self-employment tax must be ready to prove to IRS (if challenged) that they: (a) are “limited partners,” and (b) have complied with the “limited partnership” statute where their partnership was established. A taxpayer's limited involvement in the operations of a partnership won't make the taxpayer a “limited partner” for self-employment tax purposes absent proof of the above two requirements.

07-25-02 08:50 AM
Trading remotely from Nevada with an LLC prop firm

Comment:
I'm thinking of relocating to Nevada, which is exempt from state income taxes. I plan on trading remotely (from home) with a prop firm that issues K-1s to their traders.

Response:
If you live and work in Nevada, a tax-free state, and trade "remotely" with an LLC prop trading firm outside of Nevada (for example, in a state with a high state income tax), then you should not have to pay taxes in that outside state. The LLC firm's accountants may or may not issue you a state K-1 and/or instruct you on how you can avoid taxes in the home state.

When people invest in hedge funds (investment partnerships) in a high tax state and they live in a tax-free state, they may receive a K-1 for the high taxing state. However, since the cover letter from the accountants say that since the hedge fund is an investment partnership, the investor does not have "source income" in the high tax state (where they don't reside). Therefore, they don't have to file a tax return in that high tax state.

Trading is not an investment partnership, as the trader is active.

The key to avoiding taxes in the high-tax state is claiming you don't have "source income" in that state because you live and trade from another state and your income in the LLC is solely your share of your own trading account. See my prior post about how your K-1 income is derived.

07-25-02 08:56 AM
What happens if a trader deposits $25,000 into an LLC and loses it all during the year?

Question:
What happens if a trader deposits $25,000 into an LLC and loses it all during the year and quits the firm? Are there deductions that he can take and how would he go about doing that? Thanks for any help.

Answer:
Different LLC proprietary trading firms may handle this differently based on their LLC Operating Agreements.

In general, you have deposited $25,000 into an LLC firm for your "capital" account. If you lose your capital account in trading, then you have a trading loss for that capital account amount – $25,000 in this case. The LLC firm is a broker/dealer using mark-to-market (MTM) accounting, so your loss is an MTM trading loss and reportable by you on Schedule E as an ordinary loss.

To summarize, you get a full ordinary loss for your entire capital account paid, lost and closed out.

If you don't exit the LLC firm and merely let your capital account sink to zero, the LLC firm may not apply your loss to your capital account on your K-1. The firm may apply your loss to other Class member capital accounts until you replenish your account and/or your sub-trading account profits. This also varies greatly from firm to firm. In other words, some firms don't report losses on K-1s to their prop trader LLC Class 'x' members. Ask the firm and look closely at your agreement.

Testimonial from a trader who read this page and "saved himself" with this information:

-----Original Message-----
From: Exxx@aol.com
Sent: Friday, August 16, 2002 2:39 AM
To: info@greencompany.com
Subject: Re: Joe on your website

I just wanted to say thanks for the example of Joe. You just saved me from making a huge mistake and I really appreciate that. Let me explain. A proprietary firm just made me an offer to work for them. They wanted $5k down and another $500 for the training. I accepted their offer partly because I would be getting a series 55 license and because of the prospect of making big money. Until I read your article, I didn't know that I would be responsible for the loses and that I would be sued by the firm if I didn't pay. I also didn't realize that I was required to maintain the $5k deposit. I am a divorcee with a child and could not survive financially if I created trading loses and got sued. You saved me from losing my shirt and I am forever grateful.
Sincerely,
Mxxx Pyyyy