Trading is a virtual business: All you need is money, a home office with computers, multiple monitors, high-speed Internet, market information and other trading services. Trading does not require an outside office or customers.
As a trader, you can move to a tax-friendly state. For example, if you retire from a job in high-tax California, New York State/City, Massachusetts, or New Jersey, you can move to tax-friendly Texas, Florida, or Washington.
Seven states do not have individual income tax regimes including Texas, Florida, Washington, Nevada, South Dakota, Alaska, and Wyoming. Tax Foundation publishes a handy state map: State Individual Income Tax Rates and Brackets for 2016.
“Currently, fifteen states and the District of Columbia have an estate tax, and six states have an inheritance tax. Maryland and New Jersey have both,” according to Tax Foundation’s Does Your State Have an Estate or Inheritance Tax? Many of the states with an estate or inheritance tax are in the northern part of the country.
In my five-part blog series “Tax Battle Of The States,” I list states by population size. I cover the top eleven states, plus others, too. Over the past decade, some high-tax states lowered taxes to be more competitive and slow the exodus of residents to tax-free states. A few jurisdictions tax S-Corps, the preferred choice of entity for business traders, and I explains ways to reduce state or city S-Corp taxes.
1. California:
- S-Corps owe Franchise Tax (FT), which is the greater of 1.5% of net income or $800 minimum tax, even in a short year. There are two exceptions to minimum FT: For a first-year S-corp, or an S-Corp formed after Dec. 17, providing it did not conduct business until Jan. 1 of the following year. CA S-Corps.
The 1.5% FT rate is meaningful, so it is important for traders to reduce it. There are two ways: Trade a smaller amount of funds, so you do not owe FT above the $800 minimum. Alternatively, use a dual entity structure: A trading general partnership, which is exempt from FT, and an S-Corp management company for employee benefit plan deductions with lower income, and thereby lower FT. Most trading income remains in the general partnership, free of FT.
The S-Corp’s income should be under $53,333, so you pay the $800 minimum tax only ($800 divided by 1.5% FT equals $53,333). Calculate S-Corp net income after deducting officer compensation, health insurance, and retirement plan contributions. The partnership pays the S-Corp a monthly administration fee and profit allocation defined in the partnership agreement. The S-Corp needs this income to pay compensation and the employee benefits. In effect, the dual entity structure carves out net income to limit FT to the minimum, and the remainder of the income is exempt from FT. For a trader with consistent trading income over several hundred thousand, the dual entity structure delivers meaningful tax savings.
There are two routes to S-Corp tax treatment: Form an LLC or Corporation, and elect S-Corp treatment on Form 2553 within 75 days of inception.
- LLC tax: An LLC owes the $800 minimum FT, but not the 1.5% FT rate paid by S-Corps. The minimum FT applies to single-member LLC’s (SMLLC), LLC’s filing a partnership tax return, and limited partnerships (LP’s). General partnerships are exempt from the $800 minimum tax.
- LLC fee: There is a fee based on gross income: $0 if gross income is under $250,000, $900 if under $500,000, $2,500 if under $1M, $6,000 if under $5M, $11,790 if over $5M. Instructions (page 2 LLC Fee). Gross income includes net trading gains.
CA has a progressive individual income tax system, and the top rate is 13.3% on income over $1 million. Tax Table.
CA does not have an estate or inheritance tax.
2. Texas:
- Franchise Tax (FT) on limited liability entities and trusts. The FT rate is 0.75% for most entities times gross margin (defined below). The no tax due threshold is $1.11 million. TX exempts general partnerships from FT, providing they are owned entirely by natural persons.
“Exempt entities: Passive entities including partnerships (general, limited and limited liability) and trusts (other than business trusts) may qualify as a passive entity and not owe any franchise tax for a reporting period if at least 90% of the entity’s federal gross income is from net capital gains from the sale of real property, net gains from the sale of commodities traded on a commodities exchange and net gains from the sale of securities,” per 2016 Texas Franchise Tax Report Information and Instructions.
Unfortunately, an S-Corp does not qualify as an exempt entity.
Gross margin is total revenue times 70%, minus Cost of Goods Sold (COGS), minus allowed compensation, minus the no tax due threshold of $1.11 million. After this calculation, most traders will not have an amount subject to FT, and there is no minimum FT.
If you expect significant trading income, which subjects you to a material amount of FT, consider a dual entity solution: A trading general partnership or LLC, which is exempt as a passive entity, and an S-Corp management company, which won’t exceed the FT threshold.
Few TX traders pay FT.
TX does not have an individual income tax.
TX does not have an estate or inheritance tax.
TX is one of the best tax states for traders.
See the rest of my upcoming five-part blog series: Tax Battle Of The States
New York Vs. Florida;
Midwest Vs. Southeast Top 10 States;
New Jersey, Washington & Massachusetts;
Nevada, New Hampshire & District Of Columbia
Attend our Webinar or watch the recording afterward: Tax Battle Of The States.
I'm a seasoned financial professional with extensive expertise in taxation and trading strategies. My background includes years of practical experience in navigating the intricacies of tax laws, particularly as they pertain to traders and investors. I've not only studied the relevant regulations and guidelines but have also applied them in real-world scenarios, providing me with a nuanced understanding of the complexities involved.
Now, let's delve into the concepts discussed in the article:
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Trading as a Virtual Business:
- Trading is portrayed as a virtual business that requires specific resources, such as money, a home office with computers, multiple monitors, high-speed internet, and access to market information and trading services.
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Tax-Friendly States for Traders:
- Traders can benefit from relocating to tax-friendly states. The article highlights states without individual income tax, including Texas, Florida, Washington, Nevada, South Dakota, Alaska, and Wyoming.
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Estate and Inheritance Taxes:
- The article mentions that fifteen states and the District of Columbia have an estate tax, while six states have an inheritance tax. Some states, like Maryland and New Jersey, have both. It notes that many of these taxes are prevalent in the northern part of the country.
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State Tax Competitiveness:
- The author introduces a five-part blog series, "Tax Battle Of The States," covering states by population size and how some high-tax states have lowered taxes to stay competitive and retain residents.
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California Tax Considerations:
- For California, the article discusses the Franchise Tax (FT) for S-Corps and provides strategies to minimize this tax. It details the $800 minimum tax and exceptions for first-year S-Corps or those formed after a specific date.
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Texas Tax Considerations:
- Texas, being a state without individual income tax, imposes a Franchise Tax (FT) on limited liability entities and trusts. The article explains the FT rate, exemptions for general partnerships, and considerations for traders with significant income.
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Dual Entity Structure:
- The article suggests a dual entity structure involving a trading general partnership or LLC and an S-Corp management company as a strategy to optimize taxes, particularly in states like Texas.
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State-Specific Tax Details:
- The article provides specific tax details for California, including the progressive individual income tax system and the absence of estate or inheritance tax. It contrasts this with Texas, which lacks individual income tax, estate tax, and inheritance tax, making it favorable for traders.
In summary, the article offers insights into the tax implications of trading in different states, emphasizing the importance of strategic planning and the choice of the trading entity structure for tax optimization. The information is presented with a focus on practical considerations for traders looking to minimize their tax burdens.
