How Some Proprietary Traders Under-Report Income
Proprietary traders are significantly different from retail traders. Proprietary traders don’t trade their capital. They trade the firm’s capital, usually accessed from a sub-trading account. A prop trader becomes associated with a prop-trading firm either as an independent contractor (1099-Misc), an employee (W-2) or an LLC member (Schedule K-1).
Profitable independent contractor (IC) proprietary traders receive a 1099-Misc for “non-employee compensation.” Sole proprietors use a Schedule C to report revenue and deduct business expenses. Schedule C net income is subject to federal and state income taxes, and self-employment (SE) taxes.
Reinvesting earnings are taxable income
Prop traders generate trading gains on their sub-trading account. At the end of a defined period, usually monthly, the firm presents them with a choice: Request a fee payment (distribution of earnings) or reinvest income in their sub-trading account. Some prop firms only include fee payments on annual tax form 1099-Misc. They don’t include reinvested earnings. That’s a problem: In the above scenario, reinvested earnings constitute “constructive receipt of income,” which should be reportable income. This firm’s prop traders are likely under-reporting income since many will inadvertently or purposely overlook reporting reinvested earnings on Schedule C. Taxpayers are responsible for reporting their correct income, even income that should be included on 1099s but is not.
Constructive receipt of income
In the June 2004 issue of Strategic Finance Magazine: “Constructive Receipt and the Substantial Restrictions Limitation,” Charles E. Price, Ph.D., “Treas. Regs. Sec. 1.451-2 explains that a taxpayer need not have physical possession for an amount to be included in gross income. Income that is set aside for the taxpayer, credited to an account, or otherwise made available is constructively received by the taxpayer. If the taxpayer’s control is subject to “substantial limitations or restrictions,” however, the income isn’t considered to be received.”
“Constructive receipt requires an unqualified vested right to receive income – there can be no condition, limitation, or restriction that prevents the taxpayer from having unrestricted access to his or her money without penalty. The taxpayer, however, can’t waive a present right to receive income— in other words, the taxpayer may not “turn his back” on income that is already earned. But if the taxpayer requests deferral of payment prior to receiving an unqualified vested right to income, constructive receipt doesn’t occur.”
“The key to recognition or deferral is an unrestricted present right of the taxpayer to control the disposition of the income. If substantial limitations or restrictions hinder the taxpayer’s right of access to income, then recognition can be deferred. Taxpayers who seek to defer income recognition must avoid an unqualified right to control that income.”
The trader’s income is set aside and credited to his sub-trading account for his benefit. The trader receives an unrestricted, present right to control the disposition of the income, so income deferral is inappropriate.
A prop trader pays $5,000 as a deposit or expense to a prop trading firm, and the firm gives them a limited power of attorney to trade a sub-trading account containing $25,000.
In month 1, the trader earns $1,000. (Generally, a prop trader receives around 70% of trading gains in the form of non-employee compensation.) The sub-trading account balance is now $26,000. The firm offers the trader a distribution (fee payment) of $1,000, but the IC may decline (turn his back on income) and reinvest the $1,000 in the sub-trading account.
After a few additional months with trading gains, the sub-trading account balance is $30,000 containing: reinvested earnings of $5,000, $25,000 of firm capital, and no fee payments to the trader. The firm decides to allocate another $25,000, so the trader is now trading a sub-account with $55,000. At the end of the calendar year, the account balance is $65,000 containing trader earnings of $15,000, $50,000 of the firm’s capital, and no fee payments to the trader. In the above example, the firm we spoke with would not issue a 1099-Misc because they did not pay fees during the year. The trader’s $15,000 of reinvested earnings meets the IRS definition of a constructive receipt of income, so the firm should report it on a 1099-Misc.
The IRS holds the trader responsible for reporting $15,000 of revenue on Schedule C whether or not the prop trading firm issues a correct 1099-Misc. The IRS may also assess a tax penalty to the firm for under-reporting on a 1099-Misc.
Losses of reinvested earnings
Assume the same facts as in the above example; only the trader has $6,000 in trading losses in December. That leaves an account balance of $59,000, containing trader earnings of $9,000, $50,000 of the firm’s capital, and no fee payments.
It may be acceptable to net the losses against the income by issuing a 1099-Misc for $9,000. Otherwise without netting, the 1099-Misc should be for $15,000, and the prop trader can report a $6,000 business bad-debt deduction on Schedule C. Firms should provide traders’ with accounting for reinvested earnings.
Aspiring traders have two choices: Open a retail trading account or join a prop trading firm.
Retail traders place a deposit with a broker-dealer. If they want to day trade securities, four or more times in five business days, they need “pattern day trading” (PDT) privileges allowing a 4:1 margin and the minimum account size is $25,000. Otherwise, a retail trader is limited by Reg T margin rules to a 2:1 margin.
Many securities traders can’t afford $25,000, and they are drawn to prop trading firms offering higher leverage with less money required upfront. Some prop trading firms ask prop traders for a deposit or another type of payment. Some firms use murky accounting and tax classifications to avoid calling it a “deposit” because they are non-customer broker-dealers who may not accept deposits. Only customer broker-dealers accept deposits. Non-customer broker-dealers also have lower capital requirements and less regulatory scrutiny versus customer broker-dealers.
Some prop trading firms classify initial deposits and reinvested earnings as education expenses or other service expenses, reporting revenue for these payments in the firm’s books and records. But, there are conflicts with sales materials and other paperwork referring to the payments as a deposit or a share of capital.
If a prop trader loses an initial deposit, he can report a business bad-debt deduction on Schedule C, provided they have entered into an independent contractor agreement for rendering trading services.