PROPRIETARY TRADING
TRADERS
TAX

Important tax matters for proprietary traders

Some proprietary traders are treated as independent contractors (who receive Form 1099-Misc), others are LLC members (who receive Form K-1s) and still others are employees (who receive a W-2). Proprietary traders need to understand their underlying agreements and utilize tax-wise strategies that match their facts and circumstances. Not all proprietary traders and firms are alike, and different tax planning and reporting strategies are warranted.

Independent contractors receive a Form 1099-Misc. Click here.

LLC members receive a Form K-1. Click here.

Employees receive a W-2. Click here.

Deposits and how to write them off on your tax returns. Click here.

Non-resident proprietary traders. Click here.

See Robert A. Green's June 2004 article in Active Trader magazine: Many traders work for proprietary trading firms, and many others are considering it. However, too many traders fail to understand the contracts they sign with a firm and wind up getting burned later on. Know what to expect - and what you deserve - before you sign anything. Click here.

Due to all these complexities, nuances and pitfalls, we recommend that most prop traders consider a consultation with one of our attorneys. We can review your agreements and consult you on the tax matters if they are not clear to you as well.

We also recommend that prop traders sign up for our tax preparation services. We don't have to spend time on trade accounting since the firm handles that, so our fees are less then for retail traders. Visit our trader tax preparation page and figure your fees are the bottom of our range - approx $600 per return (federal and state). Plus we will find lots of ways for you to deduct non-reimbursed business expenses including home office expenses and that will save you thousands more. Click here to visit our trader tax preparation section and sign up for 2003 taxes.

You can sign up for a tax and legal consultation below. Prop trading can be an excellent way to trade more capital then you have on hand, but with that added leverage, there are added risks and pitfalls. Learn how to take advantages of the pluses and avoid and limit the risks and pitfalls.

If you have a question or just want to see how we can help you, please call us or e-mail us at info@greencompany.com. If you need help evaluating a proprietary trading firm agreement and figuring out your tax matters with this firm, purchase one of the following offers:

All consultations are done by phone and/or e-mail. Consultations may be split over several sessions.

Independent contractors receive a Form 1099-Misc.

In most cases, these "independent contractor" (IC) proprietary traders work for a broker/dealer and get paid by them as individual "sole proprietors" to manage a sub-trading account within the firm.

For tax purposes at year-end, the firm reports their compensation on Form 1099-Misc (line 7, "non-employee compensation). The proprietary trader is considered a "sole proprietor" and required to report this income on their individual tax return Schedule C (Business Profit and Loss - line 1 "Gross Receipts").

An IC prop trader should deduct their trading business expenses on that same Schedule C, including but not limited to (qualified) home office deductions (from Form 8829) and commuting if they have a home office (otherwise commuting is not deductible), meals & entertainment, (qualified) education expenses, supplies, Internet, research and much more. For a list of many possible trading business expenses, see our trader tax return examples guides. Prop traders have similar business deductions as retail traders. Our trader tax guides are excellent for prop traders as well. View and purchase these guides on our site here.

The main difference between IC prop traders and retail "customer" traders, who are also sole proprietors is that an IC prop trader's net income is deemed "earned income" and therefore subject to self-employment (SE) taxes on Schedule SE. Trading gains for retail traders are not earned income and not subject to SE taxes.

Per the IRS Web site, the total self-employment tax rate is 15.3 percent of your net earnings from self–employment. The tax is made up of two parts. The maximum amount of net earnings subject to the social security part, 12.4 percent, is below. All of your net earnings are subject to the Medicare part, 2.9 percent. The maximum amount subject to the social security part for tax years beginning in 2003 is $87,000. For 2004, that amount increases to $87,900. All net earnings of at least $400 are subject to the Medicare part.

SE taxes are costly, but there are also benefits in connection with "earned income." You may contribute to a tax-deductible retirement plan based on earned income and retail traders may not - unless they form an entity (see our entities page for more information). You may also deduct 100% of your health insurance premiums from adjusted gross income (AGI) up to the amount of your earned income. There are also some tax credits based on earned income like the child tax credit. Retail traders, using entities, have some flexibility in declaring how much earned income they have - and they declare only enough to drive their deductions and credits, whereas IC prop traders owe SE taxes on all their net income (without any flexibility).

Note, follow the argument on our message boards being made by some firms that some IC prop traders are really disguised retail accounts. If that reasoning is logical, then perhaps you can avoid paying SE taxes, if you consider yourself really to be a disguised retail trader. Careful, this argument has other profound complications. Before you even consider this idea, we strongly suggest that you consult with our firm.

In some cases, it is possible to argue IC income is "other income" - not earned income - thereby savings on self-employment taxes. Of course, without earned income, you can't set up a tax-deductible retirement plan contribution (or deduct health insurance premiums from AGI). If you seek to avoid paying SE tax on your IC income, we strongly suggest you consult with us first. We need to review all your facts and circumstances and determine if this "GTT fix" is possible. Sign up for a consultation here.

LLC members receive a Form K-1 (Partner's Share of Income, Credits, Deductions, etc.).

These traders usually become a Limited Liability Company (LLC) member in a broker/dealer entity by contributing a certain amount (usually around $25,000) to the firm's capital account (directly or through a separate deposit account).. In most cases, the proprietary trader is assigned a "sub-trading" account based on their own capital paid into the firm, and the trader keeps a high percentage of their trading gains. If the trader loses money, the firm usually charges those losses to the trader's capital account.

In almost all cases, LLCs are taxed as partnerships and the firm files an annual Form 1065 partnership tax return. The firm gives each LLC member (a partner for tax purposes) a Form K-1 at year-end. Technically, some LLCs can choose to be taxed as C-corporations. However, this is rarely the case, as it is not tax-beneficial.

Although the proprietary trader is an LLC member and "partner" in the partnership tax return, in most cases, the proprietary trader does not share in any of the other partners' income', or the firms', overall gains and losses. This is contrary to what happens in most partnerships, where partners do share in firm-wide gains and losses. Most proprietary trading firm LLCs are structured so that the Class A members – i.e., the owner/managing members – share in the gains and losses of the firm (including but not limited to their share of the proprietary trader's gains and commissions). The proprietary trader is usually a Class C or D member and they only share their "sub-trading account" gains and losses (the trading gains that they generate). Sharing agreements vary widely from firm to firm and among individual traders within each firm. Different classes of LLC equity are designed for these purposes.

The key point for tax purposes is that the allocation of gains and losses must follow "substantial economic effect." This means the K-1 tax reporting must "follow the money." It is odd that one LLC member may report a $1 million gain and another a loss, but the IRS should accept this tax reporting as proper because it does have "substantial economic effect."

Most proprietary trading firms elect to use IRC 475 mark-to-market accounting in connection with their proprietary trading activity in securities only (not commodities so they retain 60/40 treatment benefits). A few firms do not elect IRC 475 and therefore have capital gains and loss treatment.

The key point to understand is that all tax status, elections and character of income, loss and expense are determined on the entity-level, not the individual level. As a partner in a partnership for tax purposes, you are required to use the tax elections made on the entity level. This means you do not have to elect IRC 475 MTM on your individual level - but you may want to if you have trading accounts outside of the firm on your own account.

The proprietary trading firm K-1 "passes through" the gains, income, losses and expenses to the proprietary trader. Most firms won't pass through losses, as the Class A members will take them on their tax returns - a tax benefit to Class A members - even though they charged those losses against your deposit.

Note, trading gains are not "earned income" and pass through to your individual return on Schedule E (if MTM) or Schedule D (if capital gains without MTM). Only earned income is subject to self employment taxes. LLC members therefore don't have to pay self employment taxes as independent contracts and employee traders do (payroll taxes are the equivalent).

The good part of earned income is that you can set up a tax deductible retirement plan and also deduct your health insurance premiums. LLC member prop traders can't form retirement plans and deduct health insurance premiums on their trading gains from the firm.

Some prop trader LLC members do have earned income in cases they get mentor fees for training other traders, or commission overrides on recruited traders (make sure that is legitimate).

Most LLC firms do not reimburse traders for their trading business expenses outside of the firm, including but not limited to home-office expenses, meals, travel, supplies, Internet services and other trading expenses.

Some firms have "accountable plans" for reimbursing prop traders expenses outside of the firm. Make sure to "use of lose" these benefits before year-end.

If your firm does not have an accountable plan, then you can deduct all non-reimbursed expenses directly on your Schedule E, under where you report your ordinary income from MTM trading gains, net of expenses. You can also deduct home office expenses on Schedule E. These are very valuable deductions. We suggest you consult with our firm on maximizing these deductions.

Most proprietary trading firms using the LLC model only allow individuals to join as LLC members. This means that prop traders in these firms can't use entities like retail "customer" business traders for added tax benefits including retirement plans and health insurance plan deductions. Note that employee and independent contractor prop traders also may utilize retirement and health insurance plans. This is one case where the LLC prop trader comes up short on some benefits. A few prop trading firms do allow entity owners and usually single member LLCs. Ask your firm their policy.

Note from our tax attorney. "I am the most concerned about the LLC model that issues a K-1 for the upside and nothing for the downside. The lack of tax treatment symmetry is troublesome. It makes the K-1 amounts appear to be something else (e.g., either an amount that should be 1009ed or w-2ed, depending on other terms in the document used to "bring in" LLC members.

Employees receive a W-2:

See our Agreements page for information about employment jobs with prop trading firms. We cover all the tax and legal issues you should address.

Deposits and how to write them off on your tax returns:

Almost all proprietary trading firms require traders to put up a deposit when they join a firm.

Most broker dealer prop firms require $25,000 or more; similar to the account size needed for a pattern day trading retail customer account. Non-broker dealer smaller prop trading firms allow lower deposits.

The prop trading firms claim that these deposits are segregated from capital accounts (for LLC members) or the sub-trading accounts for independent contractors and employees. This is important to avoid the customer Reg T potential problems mentioned on another page here. They claim that the leverage provided the trader is unrelated to the deposit amount. When we look closely, we think it is fairly related - but that is another story.

Traders are usually required to replenish their deposits after the firms take the deposits to cover trader’s losses on the firm's trading accounts.

The question that often comes up is, "how do you report (on your tax returns) lost deposits that are not returned?"
There are two ways to lose a deposit.

First, when you leave a firm and the firm does not pay you back part or all of your deposit. This usually happens because the firm applied your deposit against your losses in the firm, in accordance with your agreement. But it can also happen if your firm goes out of business or simply chooses not to pay you back. Maybe, they just don't have the money.

Second, you stay with the firm but you lose part of your deposit (the firm applies it to losses) and the firm requires you to replenish your deposit account to the original amount. The firm only gives you a deposit credit on their books for the original amount, not the replenished extra amount, which then is lost.

Form example, if you deposit $25,000, lose money and the firm takes that $25,000 entirely and you replenish it with another $25,000. To date you have paid $50,000 of deposits and the firm gives you credit on their books for a deposit of $25,000 only. How do you report the lost $25,000 deposit?

The good answer from our tax attorney is that you can take a "business bad debt" - an "ordinary business loss." This means you can avoid the capital loss limitations of $3,000 on an individual tax return.

So as soon as you pay in more then you are credited for on the firm's books, or you leave and don't get paid back the deposit on the books (or a portion thereof), that deposit loss is a business bad debt.

LLC members report that business bad debt on Schedule E, when it’s officially lost.

Independent contractor prop traders report that business bad debt on Schedule C, when it's officially lost.

We strongly suggest you sign up for a consultation with us to review your case and tell you how to report these deposit losses on your tax return. It can be nuanced and complex.

Non-resident proprietary traders:

If you are not a US citizen or resident (a non-resident) and are a LLC member of a US based prop trading firm, you have some tax problems. Your US K-1 income is US source income on which you owe US taxes. According to some tax treaties, you also maybe taxable on your worldwide income in the US.

These are the same rules as exist for investing in a US hedge fund organized as a pass through entity (LLC or LP). For more general information for non-residents, see our international section. Click here.

Non-resident proprietary traders in U.S. proprietary trading firms are subject to U.S. income taxation and withholding solely on the earnings reported by the U.S. firm.

Most U.S. proprietary trading firms are organized as LLCs, and they file a U.S. partnership income tax return. Each LLC member, including non-resident aliens, is given a Form K-1 to report the member's share of gains, losses, income and expense. In effect, your Form K-1 represents what you earned at the firm. You owe U.S. taxes based on the earnings, not cash distributions. So, even if the firm did not pay you all your earnings, you still owe taxes in the U.S.

We have noticed that many firms are not complying with these rules and not withholding taxes. The firms face penalties. Some firms are rushing to set up international firms outside the US for their non-resident members to join instead of their US firms, to avoid these tax withholding issues. International tax planning in this regard is complex and some firms may not carefully address all tax treaty provisions. Check with our firm to make sure you won't have any tax troubles.

Our international tax attorney is very familiar with almost all tax treaties with other countries, and we can help you plan how to best handle your global tax matters (in the U.S. and your home country).

We explain the detailed rules for non-resident aliens, including proprietary traders outside the U.S., on our non-resident alien page in our GTT Resource section. Click here.

It is important to note a key difference in U.S. tax treatment. Traders outside the U.S. have tax benefits in trading "direct access" (or otherwise) vs. being a member of a U.S. proprietary trading firm that files a partnership tax return. The direct-access trader does not owe U.S. taxes on their trading gains, whereas the proprietary trader member of a U.S. LLC does owe U.S. taxes.

These rules can be complex, so we suggest you e-mail us with your questions at info@greencompany.com or call us. We will probably recommend a consultation. Click here to learn about our consultations.