Different Types of Traders
On this page, we take a look at the different tax matters for casual investors, active traders, business traders, proprietary traders, and investment managers.
“Trading” is a widely used term covering everyone from the casual investor with a dozen trades per year, to the active investor with hundreds of trades, to the business trader with a thousand trades, to proprietary traders using a proprietary trading firm’s capital, to investment managers trading for their investor clients. Let’s take a look at the various types of traders.
Over 10 million Americans have online brokerage accounts and they make a dozen or more trades per year in individual and IRA accounts. They need to deal with cost-basis reporting on securities, tax treatment for instruments traded, and deducting investment expenses as miscellaneous itemized deductions. They can expect to have some issues with consumer tax software and tax storefront services. For example, a local tax advisor may not know where to report forex transactions, how Nadex is taxed or how best to handle wash sale reporting on securities. (See our tax compliance service for Investors & Non-Traders.)
Many online traders have several hundred trades per year, but they fall short of claiming trader tax status. Often, they have another job or business activity and they don’t have sufficient time to trade for a living. They have more tax issues than the casual investor, including wash sales between individual and IRA accounts, dealing with lots of pre-business education costs, more complex tax treatment issues as they trade a wider variety of instruments, and keeping a close eye on qualification for trader tax status. (See our tax compliance service for Active Traders and we suggest using GTT Tracker to monitor and assess trader tax status.)
Retail business trader
A small minority of online traders qualify for trader tax status (business treatment). They should master the content in our Trader Tax Center and consider our full array of services targeted to their special needs. Business traders trade their own funds in a retail or customer account.
Pattern day trader
The Federal Reserve coined the term “pattern day trader” (PDT) in connection with its Reg T margin lending rules on the purchase of securities on margin. The default margin for a retail account is 2:1. Day traders are allowed up to 4:1 intraday leverage providing they have a PDT account with a minimum securities account size of $25,000. Many PDT accounts never rise to the level of trader tax status.
Many traders who can’t meet the pattern day trader minimum account size for securities are attracted to opportunities with proprietary trading firms, who are known to offer traders far greater leverage in return for low deposits. Prop firms invite traders to join their firm in one of two ways. The larger prop trading firms are registered as non-customer broker/dealers and regulators prefer they admit prop traders as (lower class) LLC members of the firm. These LLC-member traders receive an annual Schedule K-1 with their allocation of trading performance. Smaller prop firms are not registered or regulated and they often are inter-connected with education firms. After paying for education and passing tests, these firms may invite graduates to become independent-contractor traders earning non-employee compensation reported on an annual tax Form 1099-Misc.
There are many important tax, regulatory and legal issues to be aware of in dealing with prop firms and traders should be educated on the subject. There is no standard deal and many prop trading firms offer different terms and conditions. Prop traders want to deduct business expenses or unreimbursed partnership expenses (UPE) have employee-benefit plan deductions and consider using an entity to sign their prop-trading firm agreements. Prop traders don’t need to account for trading gains and losses as the firm handles that. (We provide tax compliance services for prop traders and prop trading firms, and there are many special tax matters and strategies that apply — sign up under Active Traders. Read our chapter on proprietary trading in Green’s Trader Tax Guide.)
Investment management is when you trade money belonging to investors. As you can imagine, handling other people’s money is serious business and there is a huge body of investor-protection law and regulation on securities, commodities and forex. The investment manager may need various licenses and to register with the regulator in charge. (Read Investment Management Services for more information about regulation.) Investment managers handle two types of investors: separately managed accounts (SMAs) and hedge funds (or commodity or forex pools). In an SMA, the client maintains a customer account, granting trading power to the investment manager. In a hedge fund, the investor pools his money for an equity interest in the fund, receiving an annual Schedule K-1 for his allocation of income and expense.
There are important differences in tax treatment. SMAs cannot claim trader tax status because the investment manager is responsible for the trading, not the investor. (The investment manager also doesn’t have trader tax status, but they have business treatment from providing investment management services.) With a hedge fund structure, the investment manager is generally an owner/trader of the fund, and brings trader tax status to the entity level. That unlocks other tax breaks like Section 475, too. Additionally, as an owner of the hedge fund, the investment manager can be paid a profit allocation — otherwise known as carried interest — in lieu of an incentive advisory fee. The profit allocation has tax advantages like reporting a share of capital gains rather than ordinary income also subject to payroll taxes (FICA and Medicare). In an SMA, the investor deals with accounting, not the investment manager. In a hedge fund, the investment manager is responsible for complex investor-level accounting. (We provide tax compliance services and accounting services for investment managers, and there are many special tax matters and strategies that apply.)
For more in-depth information on different types of traders, read Green’s Trader Tax Guide.
If you are unsure of your situation and available tax breaks, contact us for help.