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In today's episode, I'm going to teach you how to set up your day trading in a business account using either an LLC or a corporation. This way, you can take advantage of all the tax incentives that other small business owners in the United States benefit from.
Many day traders don't think of themselves as small business owners, but in fact, through the eyes of the federal government, if you achieve trader tax status—which you will if you're actively trading—you can deduct all of the reasonable and necessary expenses related to trading. By doing it in an LLC, you get additional benefits.
This is something that traders don't usually think about until after the fact. When it comes to the end of the year, you realize you're going to owe a lot more tax than you were expecting, and you're left scrambling. There are some things you can do right now that will help you save on your taxes this year. There are also some things you can implement that will help you even more in the years ahead.
So, let's go ahead and dive into today's class on tax planning.
Now, we spend a lot of time talking about trading strategy—how to improve your accuracy, your profit-loss ratio, and how to improve your discipline. Those are all very important. But something that I've said before is that at the end of the year, you could have two traders who make the exact same amount of money, but one walks away with more money in their pocket because they've implemented some of the strategies that I'm going to share with you in today's episode.
So, what we really have to think about is: what does it mean to be day trading as a business? What are the benefits of day trading in an LLC or a corporate account?
Well, the first is that we can deduct all necessary and reasonable expenses related to producing the income. So, let's just say you've been trading. What are some of the expenses related to trading?
Now, you might not think of them off the top of your head, but as I look around right now, I'm seeing computers, I'm seeing monitors, and I know I'm using electricity for powering all of this. I know I've got an internet connection, right? So, there are definitely things I'm spending money on.
What about my subscription to scan to charts or to Newsfeed? What about seminars you go to? What about courses that you take? All of those are expenses that are necessary and reasonable for you to be able to produce your trading profits.
Now, even if you're losing money, you should still be itemizing all of your expenses so you can add them as losses, which offset other income or can be a carry-forward loss. So, let's just say you total it all out to being $10,000 in expenses over the course of the year. That's not unreasonable when you think of the cost of software, the cost of all the equipment, and everything else. But of course, you've got to make sure you've got receipts, and you can itemize all of it.
The first benefit is being able to itemize all of those deductions and those expenses and deduct them against your income.
The second benefit is that you will get a wash sales exemption. If you've ever gotten your $199 at the end of the year, you may see that it shows you made more money than you actually made, and it's because you had wash sales that were disallowed.
We're going to talk more about what that means, but when you day trade as a business, when you are eligible for trader tax status and you opt in for mark-to-market accounting, you will be completely exempt from wash sales. I'll walk you through how to make those filings and how to do that.
Number three: you get to deduct your health insurance if you set up a business.
Number four: you can deduct 401(k) contributions up to $69,000 per year. You are a small business owner, and the government wants to encourage you to save money for retirement. You've got $69,000 per year that you can deduct against your income in the form of 401(k) contributions.
You get asset protection, so all of the assets inside the corporation are protected. If something happens to you, if you get sued for something, or whatever the case may be, the assets inside that LLC or that corporation are protected.
The last benefit is the ability to write off unlimited losses against income—both current income and with a carry-forward loss for future income.
We've all heard about how Trump paid no income tax for like a decade or whatever. It's because he had a huge loss, and he was able to carry it forward. The tax code allows for that. So, if you had a big loss trading, that's terrible, but at least it gets to serve some benefit.
Now, if you are not aware of some of the techniques I'm going to share with you, you wouldn't be taking that full loss as a deduction in one year. You wouldn't be offsetting it on current income. You would be limited to only deducting $3,000 of that loss. Even if you lost a million dollars, you could only deduct $3,000 a year unless you implement some of these techniques I'm going to share with you.
I'll tell you that I've implemented all these techniques in my own trading, and it has saved me millions of dollars in unnecessary tax payments. This is all not only legal; this is encouraged by the IRS. A lot of these are the same deductions and benefits that are available to every small business owner. It's just that traders don't typically think of themselves as small business owners.
The process of creating an LLC or corporation is fairly straightforward. Typically, we would do an S Corp election, so we have the LLC treated as an S Corp. An S Corp is a corporation where all of the income is passed through to the shareholders. The "S" is for shareholders.
Typically, a corporation pays its own income tax, and then all of the owners would receive a dividend, and they would pay income tax as well, which is double taxation. That's true with big companies, but with small companies—especially privately held companies with just one member or one owner—we typically would opt for S status.
So, we would be an S Corp, and that means the corporation doesn't pay its own tax; all the income flows through to our personal tax return. So, that's what we would want: either an LLC treated as an S Corp or a proper corporation with the S Corp election.
Once you create the LLC—which you can do online super easily in pretty much every state—you can create an LLC, create an S Corp, and get your EIN (that's your federal tax identification number). Once you have that number, you can open a bank account, a trading account, and a credit card for the business.
By doing that, all of the money related to the business stays inside the business. All the expenses stay inside the business, and all the income stays inside the business. It makes it very easy at the end of the year to run a report and see the total profit.
AMX MasterCard and others have integrations where you can import all of the trades right into a QuickBooks file, and it'll give you all of your expenses. It groups them into their categories, and then you just print that out and give it to your CPA. They make it so easy for small business owners.
Now, you have to make sure that when you actually open your broker account, you open it in the name of the business using the company's EIN. Some brokers will charge you more money for opening a corporate account. Some brokers even have higher minimum deposits for opening a corporate account, but not all of them.
The broker that I use, LightSpeed, will charge you a little bit more in data fees, but they don't have a higher minimum deposit. I've heard that Charles Schwab, however, has a higher minimum deposit if you're trying to open a corporate account. So, you have to shop around a little bit.
If you've got a broker that you really like and you still want to use them, then that's where you may have to be more creative in terms of how you're going to find the balance. You could still trade in your personal name and benefit from taking the deductions when you have the trader tax status, and I'll walk you through that in just a second.
Being able to segregate and deduct all the expenses related to the company makes a lot of sense. It keeps it nice and organized. When you've got excess profits, you can contribute them to a 401(k). The current limit is $69,000 per year with an employer profit match.
You get an employer match and then you get profit sharing.
Let's say you've got $50,000 of profit. So, $50,000 of profit, and then you've got your $10,000 of equipment that you spent. Then you take these other deductions. You realize, "Wait a second, I'm going to do a little bit for a 401(k). I've got my accounting fees; I've got my CPA." You start adding these up, and next thing you know, you've got a number of deductions, bringing your income down from what was initially $50,000 to maybe $35,000 or something like that.
To me, it's a no-brainer to set up your trading in a business account.
When you go to the IRS on their website, they have a section called Topic 429. Topic 429 is specifically for traders in securities, and what they say is that eligible traders can deduct reasonable and necessary expenses related to producing their profits.
Your education costs, software costs, computer equipment, office rental, internet, professional fees, accounting fees—all of those expenses are necessary and reasonable for your small business.
To be eligible for the trader tax status, you have to meet all the following conditions:
1. You must seek to profit from daily movements in the market.
2. Your activity must be substantial.
3. You must carry on the activity with continuity and regularity.
These are all easily done.
Now, if you were to get audited, some additional factors that the IRS agent might look at would be your typical holding period for securities bought and sold, the frequency and dollar amount of your trades during the year, the extent to which you pursue the activity to produce income for your livelihood, and the amount of time you devote to the activity.
I think it's fairly safe to say that anyone who is a full-time trader, who is trading most days out of the week, and who is sitting down trying to trade the market—even if you also have W-2 income—if you're focusing on trading and it's your goal to make that your bread and butter, then you would be eligible for trader tax status.
As always, I would encourage you to consult with a CPA and make sure that they agree before you make any changes in your accounting status or the way you're filing. Always make sure you consult a CPA. I'm a trader, not a CPA, but this is stuff that I've learned over the years from my own accountants and just from my own experiences creating accounts and businesses and setting them up so I can take advantage of the same small business deductions that everyone else gets.
When you are eligible for trader tax status, you can write off all the expenses related to trading, which is great. But you'll continue to face wash sales, and you're limited to $3,000 a year in capital losses.
If you had a year where you lost $50,000, you would actually only be able to write off $3,000 of it against your current income. The remaining $47,000 you would be able to carry forward and take $3,000 a year for the next 20 years or whatever it is. It would take a long time before you can fully utilize all of those losses.
So, what most active traders are going to want to do is look at taking a big loss. It's not ideal, but you want to be able to write it off against current income like today.
What we end up doing is we have to file for mark-to-market accounting in order for our wash sales to be disallowed and for us to have an unlimited amount that we can write off in losses against income.
The way the wash sales work is that when they were originally created, the regulation was to prevent people from selling a position in December and then buying it back in January. The reason people did that was because they wanted to take a loss in December to offset income and then just buy back the stock in January for basically the same price. The IRS said, "No, you can't do that."
They said if you buy back a substantially similar position within 30 days, you're not allowed to write off the initial loss. That's a problem for day traders who often are buying and selling shares like crazy of the same stock.
Now you can't write off the initial loss, and I've seen this happen to a lot of traders where they get their $199 at the end of the year, and it shows they made more money than they actually made because of the wash sales not being allowed. If that's happened to you, it is super frustrating. It feels like it doesn't make sense, and it doesn't. It's sort of an archaic rule that applies for very specific situations and shouldn't apply for day trading.
Rather than change that rule and make it clearer about who it applies to, they have something else you can do, which is apply for mark-to-market accounting.
When you change your account to mark-to-market, wash sales become exempt. You no longer have wash sales, and the second thing that happens is you can write off all of your losses against income. You are no longer limited to $3,000 in capital losses.
So, let's just say you lost $50,000 day trading and you made $50,000 on a W-2. You would be able to say, "I have zero income that year. I have zero tax."
At least it gives you a benefit. Additionally, you would have your $110,000 or whatever it was in reasonable expenses, so you'd actually be down $10,000 on the year, and that would become a carry-forward loss.
You could apply that then to the next year. So now, the next year you come in and you're up $50,000 on your W-2, and you're up, let's say, $225,000 here, and you still got your $110,000 in expenses. You have now the $10,000 that you carry forward from the year before.
So we go from $75,000 to $65,000 to $55,000, and boom! Now all of a sudden, you've reduced your taxes from $50,000—which at best, if you hadn't done mark-to-market, you only would have been able to write off $3,000, right?
You wouldn't have been able to deduct any of this if you didn't know about trader tax status. So instead of being negative $10,000, you would have paid income tax on $47,000 in profit.
Wow! We just made a huge swing there.
Some people say, "Is this really all necessary? If I'm a beginner trader, I don't even make that much money." You might not make that much money; you might even lose money. But if you have expenses related to trading and you have other income, then you can offset that.
You could also just book and create the carry-forward losses that you could apply in the future when you hopefully turn the corner and start producing profit.
I know it's a little bit of a pain to think about this stuff. It's not as hard as learning how to trade, though. This is just sort of the accounting at the end of the day. You can always hire a CPA, and they'll give you this type of audit. They'll review your situation and give you some recommendations. They'll tell you, "Based on where you're at, these are things you can do to be smarter."
Some of these things you can implement right now, and others you have to wait because it's too late in the year. The trader tax status that you can file when you file your next return means that all of the expenses you've incurred this year related to trading should be documented.
You should have receipts and keep them all documented so you know exactly how much you've spent and can back it up as reasonable and necessary. You can already do that starting today. That can be done retroactively, but the mark-to-market election has a deadline.
You can file the form 3115 with the IRS, but you have to do it by April 15th of that year. If it's past April 15th, then you miss the cutoff for this year. You could file it now, which is fine, but it'll take effect January 1st of next year.
Once you file this change in accounting method (3115), you've got to notify your broker that you've changed your accounting method because then they're going to go in and change your reports so you no longer have the wash sales.
It's super important that you remember to do that.
Now you know how to set up an LLC or an S Corp. Both of these can be done on your own. You can also, of course, consult a CPA or an attorney to help you set them up and file it with the Secretary of State. They're fairly straightforward. People set these up all day, every day. I mean, they're very common.
These are the two most common companies for small businesses, and the reason is that it's a pass-through entity, so you don't have double taxation. By doing this, now you get to reap all the benefits that all the other small business owners get.
You can make contributions to a 401(k). The company can make them for you. You're the only employee, but you get to make those contributions. You're entitled to make up to $69,000 a year—that's the current limit. That's a huge amount of money that you can put into a 401(k).
Let's do a scenario here where you make $500,000 in trading profits. All right, you make $500,000 in profits from the business. $69,000 goes right into the 401(k)—boom! That's done.
Now you've saved $69,000. Let's say you've got $21,000 in expenses related to running the business. So now you're at $90,000. You don't have to worry about wash sales. You made $500,000 trading. It's not inflated because of wash sales; it's exactly what you made.
Now you've got your 401(k) and your expenses, so you just reduce your taxable gain from $500,000 to $410,000.
Now you pay yourself some wages—that's the money you take for yourself for covering your cost of living. Let's say in this scenario you're taking $20,000 a month.
So, minus $240,000, so now you're down to $170,000. That's still sitting in the account at the end of the year.
With that money that's still sitting in the account, you can do a couple of different things. Number one, you could say, "All right, it's $170,000 that is income, so I'm going to pay my income tax on it, and it is what it is."
You could consult with your CPA and an attorney and ask if there are investments that you could make that give you a tax deduction. There are certain types of investments that you can make that give you an investment tax credit, like investing in solar.
You could buy a $170,000 solar farm, get bonus depreciation, and deduct that against your income. For the next 30 years, you're getting an annual residual income from the solar farm.
You can invest in a self-storage unit. You could invest in an RV park. There are a lot of investments that are specifically targeted for people that have high income because those types of investments include tax deductions, bonus depreciation, or investment tax credits.
Those are the ways that the government subsidizes and incentivizes people to invest in certain areas that they deem worthy. They give you that incentive for solar because they want you to invest in solar.
Now you can start to think about ways that you can take the excess profit that you've got and, rather than just pay 35-40% tax on it—whatever it happens to be at your income bracket—you can start to reinvest that money and build your net worth.
This all comes back, though, to the beginning, which is treating day trading as a business. If you're not claiming your trader tax status, if you're not doing mark-to-market accounting, you're already way overpaying. You're not taking your deductions, and you're dealing with wash sales.
Just by doing those two things, you're taking a big step forward. By incorporating and trading in a business account, now you've unlocked more things you can do. You've got your 401(k), you've got your health premiums that you can deduct, and you've got other things you can do.
Now you want to start treating this as if you're an investment account manager. Now you've got your trading, but you've also got long-term investments. This is how the top 1% of traders scale up their net worth.
You've got to think about this as a business.
All right, so I hope you found this really helpful. As always, please consult a CPA before making any changes with your taxes. If you have any comments, please put them below. I'll come back and answer them, and I hope you subscribe to the channel. I'll see you for the next upload real soon.
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