There are many things that traders need to consider to continuously grow their wealth. One of the things that come to mind when traders want to expand is incorporation. Incorporation is the process that a business can become a legal company. This typically involves forming a business structure, drafting articles of incorporation and identifying the firm’s shareholders.
Although dealing with all the necessary paperworks can be such a hassle but there are several benefits to becoming a corporation. When you incorporate a business, you can have personal liability protection, increase the credibility of your brand, give your corporation indefinite life and more.
When taking this step, there are several things to think about including the kind of corporate identity that would be best for your business. Do you need an LLC, S-Corporation, Corporation or what about a partnership?
If you are unsure whether you need sole proprietorship or entity, here are some important things to know:
Sole Proprietorship
Sole proprietorships are a common direction that individual traders choose when incorporating. However, there are a couple of disadvantages in this route. For example, your status as a trader could affect your ability to prove that what you are doing is a legitimate business. You can run the risk of your tax status being denied and lead to the disallowance of your accounting method, denial of your ordinary losses and being capped at $3,000 only.
The IRS has a vague definition of what a trader is in terms of tax purposes. The guidelines continue to change and evolve, based on cases that involve individual taxpayers or sole proprietors, which the IRS typically deems more suspicious than formal entities.
As a sole proprietor, you will also more exposed to financial risks than other legal entities. This is largely because your personal and business assets aren’t separated. One mistake and you could lose your personal assets, your cars or your home.
Aside from this risk, you also need to deal with the disadvantage of not being allowed to make tax-advantaged retirement contributions. This is because your trading income is not considered as self-employment income.
Tax deductions are very limited in this arena. Those who do not choose market-to-market accounting will be in an odd position to report their income as capital gain Schedule D but their expenses will be ordinary income on Schedule C. The reports on Schedule C will have no income so it will constantly reflect losses.
This kind of discrepancy can just give you a bad rep with the IRS. It will show that you are running a losing business, which will make them want to inspect your returns even more closely.
Entities
Many prefer to form a trader entity because of the many advantages you can get from it. When you form a legal business entity, you can establish a retirement plan and other tax-deferred employee benefit plans, among many other things.
Entities are a great solution for traders who want to reduce being questioned too much by the IRS. However, you still need to qualify as a trader and have a good level of business activity. This is also advisable if you missed the April 15th deadline to file market-to-market accounting. You can build the entity and choose market-to-market for the whole tax year.
The main entity structures are Limited Partnership, LLC or Limited Liability Company, C-Corporation and S-Corporation. Your chosen entity needs to be registered in the state where your business is conducted. If you are paying payroll for medical insurance or retirement accounts, it should be registered in your home state. In some cases, traders have the option of registering in a state that doesn’t tax income from entities.
Forming a legal entity can help you stabilize expense deductions and business activities. When you choose market-to-market accounting method with your legal entity, you can enjoy business deductions of up to $20,000 per year. Even if you have substantial losses, you can still deduct them as ordinary losses with the $3,000 capital gains waiver.
In Conclusion
Having a business entity outweighs the advantages of sole proprietorship. While both of these have understandable risks, forming a legal entity has been known to be the better direction among the two choices.
To learn more about incorporation for traders, tax laws and more, seek assistance from our knowledgeable tax advisors.