Beware the Ides of March

March 15, 2008

Damn. The Ides of March. I HATE this day, not because I’m a big Julius Ceasar fan, but because of what’s this day inevitably brings - April 15th.

This post will not mean much to most of you, but I’ve FINALLY found something that makes sense for K-1’s. I’m not sure why the hell my firm cannot write up something like this. But here’s the motherload (text also available after the jump for future references). Hope it helps. =)

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.