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April 20, 2005 � Issue #216 | |
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Trading Tip When Day Trading Just Plain Makes Sense By D.R. Barton, Jr.
Tax Tip Self-Employment Tax on LLCs and Limited Partners Listening In... Confidence
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When Day Trading Just Plain Makes Sense Trading Tip by D. R. Barton, Jr.
-- Samuel Johnson The eulogy for day trading has been written many times in the past several years. Feeling the heat from the Wall Street vanguard (who were having their profits margins cut by hoards of stay-at-home traders), regulators made it tougher for the �small player� to qualify. Day traders have been belittled in the press as gunslingers. And the list goes on� So why does day trading continue to thrive? Statistics show that a smaller cadre of day traders are now trading more share volume in absolute numbers than the vast hoards who had taken to computer screens at the turn of the millennium. Day trading has some inherent advantages that suit the temperament of a large number of traders. Let�s take a look at these advantages and see if this style of trading may have a place in your trading plan. Advantage #1: No overnight risk. For a trader who is trying to stay in the game for the long haul, this is one of the biggest natural advantages in the trading world. While we can understand this advantage intuitively (sleep better at night, etc.), let�s see if the concept bears any fruit quantitatively. I used the excellent software that is under development by Chris Anderson and Van Tharp called Know Your System and tested using a suitable proxy for overnight risk. Here�s the methodology: Test two similar hypothetical trade distributions. Each distribution has the same expectancy and is tested across the same number of trades. The only difference is that the first distribution simulates intra-day trading and has its biggest loss as �1.5R, while the second distribution used represents the effect of taking on overnight risk by including a �5.0R loss in the distribution. This simulates having a one-dollar stop and when a company pre-announces reduced earnings and opens down five dollars. Here is are our starting data:
What were our results? As you can imagine, the volatility of our equity curve increased greatly when we added the possibility of a big loss. Our average drawdown doubled, while our average gain stayed the same. This alone is significant. But the increased volatility had a much more telling effect; the optimum risk size (defined as the amount of equity that we could risk per trade to achieve the best reward-to-risk ratio) was 2.5 times smaller for the distribution that included overnight risk. Advantage #2: Frequency of trade. We can make a good comparison of any numbers of systems if we know the expectancy and the frequency of trade of the each system. For those of you not familiar with expectancy, it is a measure of how much a system makes per dollar risked. In the example above, you make 0.12 dollars, on average, for every dollar risked. (For more information on expectancy and frequency of trade please refer to Chapter 13 in �Safe Strategies for Financial Fre-edom�.) Those of you who are familiar with expectancy calculations may have looked at the numbers in the previous section and thought, �an expectancy of 0.12 is very low.� But remember that expectancy must be coupled with frequency in order to provide a meaningful comparison. Recall that we assumed 500 trades per year using this system. At that frequency this could be very profitable system, returning 60 percent per year if one risked one percent per trade. Remember that high trade frequency is a double-edged sword. It makes systems with even small expectancies very profitable. But it also turns systems with negative expectancies into money pits. Having systems that work is important in any style of trading, but in day trading, using a strategy that doesn�t work can cause rapid disaster. Advantage #3: Immediate feedback. This advantage tends to separate the day traders from the swing and position traders. For many folks, immediate feedback is a very reassuring characteristic. Lessons are learned more quickly. Positive actions are re-enforced more quickly. For action-oriented personalities, day trading is a perfect fit. Day trading is not a style that suits everyone. But for those that thrive on immediate feedback and can make quick decisions, the benefits are many. I talked last week about one of the best traders that I know. Brad Martin, who was a floor trader at in Chicago for 14 years has left the floor and used his trading skills on the electronic platforms. He puts the advantages discussed above to work every day. For more information on Brad, see last week�s article by clicking here. For those of you who are interested in Day Trading, Brad and I have designed a workshop that gives you detailed written systems that can jump-start your trading. And we take you through real-time simulations to help you learn these strategies in a hands-on fashion. For more on this workshop click this link. Brad and I have also put together a Swing Trading workshop that is really incredible. It is filled with detailed trading systems that we both use. And we teach those systems by taking you through trading simulations where you apply the strategies along with us on real market data � you start building your confidence right in the workshop! For more on this workshop with Brad�s proven strategies and thought processes, click here.
Editors Note: Throughout the issues you will see certain words with odd spellings, such as Fre-edom and mort-gage. This is because spam filters are likely to block message that contain certain words and this is one solution. |
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Tax Tip of the Week Self-Employment Tax on LLCs and Limited Partners by Stephen S. Meredith, CPA, PLL
Do Limited Partners and LLC Members pay Self-Employment Tax? At this time, the answer is not so easy to explain for LLC�s. In the early 1970�s the Self-Employment Tax rate was low and only applied to a small amount of wages. Everyone who invested in a Limited Partnership wanted to include their income as earned income to increase their Social Security Benefits. Congress passed a set of laws in the mid-1970�s to address this issue because they felt that investors should not count this �passive� income as earned income. Internal Revenue Code section 1402 addressed some of these issues. Specifically, section 1402(a)(13) states that limited partners may not include any distributions, except guaranteed payments, as self-employment income. LLC members have limited personal liability by State law in most states, just like limited partners. LLC�s generally file partnership income tax returns unless they are a single member LLC or make an election to be taxed as a corporation. Most states which have passed Limited Liability Company statutes say that if an LLC member actively participates in the day-to-day operations they still have limited liability. Each state has had the Internal Revenue Service review their State Limited Liability Statute to get a written opinion as to whether they will be taxed as a limited partnership, and all have a letter saying they will be taxed like limited partnerships. The Internal Revenue Service tried to clarify whether LLC members who worked in the business had to pay self-employment tax in 1997. They issued proposed regulation 1.1402(a)-2 which basically said that LLC members would be subject to self-employment tax if they did one of several things; had some personal liability under state law, had authority to enter into contracts on behalf of the LLC, or worked more than 500 hours in the LLC per year. They also said that members in LLC�s that were in various consulting fields would automatically have all profits classified as self-employment income. Congress saw this as applying self-employment tax to people who actually worked in the business, which was alright, but also to any professional in any one of the consulting fields, which they did not like. Congress passed the Tax reform Act of 1998 and instructed IRS that they could not implement the proposed regulations and gave them several years to propose new regulations. IRS has never proposed new regulations. Unfortunately, when doing an audit many IRS examiners are still using the proposed regulations that Congress struck down. That leaves us with the same situation that we had before 1997. LLC�s are not defined in the Internal Revenue Code at all, unlike limited partnerships; they are simply an organization existing under State law that is taxed as a limited partnership. Limited Partnerships are not permitted to let limited partners pay self-employment tax except on Guaranteed Payments. Section 1402(a)(13) is clear and unequivocal. An aggressive tax preparer might take the position that none of the LLC or Limited Partner income is subject to self-employment tax under 1304(a)(13), and be correct. A conservative tax preparer might take the position that all earnings are subject to Self-Employment tax because the person worked in the business full time and would be considered partially or fully liable under State laws for the business, and be correct based on State law. The middle road, and easy solution, is to pay the members a Guaranteed Payment, maybe a monthly draw, which is equal each month and reflects the amount of work they do. Then they could take any other profits and not be subject to the Self-Employment tax. Also be aware that if you take the aggressive position, you may not be able to use the cash method of accounting for the tax return. Any partnership which allocates over 35% of losses to limited partners is subject to the tax shelter rules, and must use the accrual method for their taxes. This is not a problem if you have profits to allocate. See sections 448, 464(e)(2), and 1256(e)(3)(b). Another solution is to file form 8832 and elect to be taxed as a corporation. You can also simply file form 2553 and make the election to be taxed as an S Corporation. If you file form 2553, form 8832 is not needed. Being an S-Corp has the added advantage of preserving the flow-through nature of the business income and expenses, while permitting the owner to take a salary, do tax withholding, and avoid the whole self-employment tax issue. As long as a reasonable wage is paid, the S-Corp profits won�t be presumed to be self-employment income. The IRS continues to audit LLC�s on the self-employment tax issue and tries to apply the proposed regs that were abandoned. The IRS announced over a year ago that they were starting an initiative to examine S-Corp returns on the reasonable wage issue. To be safe, consult your own tax advisor regarding how they are preparing you returns and ask about the risk involved in these various positions.
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Excerpts from Dr. Tharp's Mastermind Discussion Forum
Confidence
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Quote of the Week "Experience is not what happens to a man. It is what a man does with what happens to him." ~Aldous Leonard Huxley |
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