I had conversations with two day traders today who were relying on articles stating that some traders take a salary from their corporate trading entities. There was no tax problem here but I just felt that it was important to distinguish between tax fact and opinion before delving into tax planning. I pointed out that there is no substantial legal authority specifically approving that position when the only source of corporate revenue is trading activity that Congress has explicitly excluded from net earnings from self-employment under Internal Revenue Code section 1402(a). One trader suggested that because trading proceeds are reported on a Form 1099, this indicates that the payment is attributable to earnings. That is a misinterpretation of Form 1099 which reports gross proceeds not earned income.
The legality of a salary in this narrow fact pattern has never been tested where the sole source of corporate revenue is securities or commodities trading that is excluded from net earnings from self-employment. The likely reason for the lack of challenges is that the salary transaction, viewed by itself, tends to increase rather than decrease total federal tax, because it creates wages subject to FICA taxes on both the employee and employer sides. The IRS generally does not prioritize challenging positions that increase the tax reported by the taxpayer. However, some taxpayers appear to be using this wage-creation step to support a second step that does lower overall taxes, most commonly by generating “earned income” to allow large retirement plan contributions or other employee-benefit deductions.
A future IRS challenge could invoke the substance-over-form doctrine and argue that paying a salary from trading profits, solely to create retirement plan eligibility, is a circular transaction that undermines the purpose of the section 1402(a) exclusion of trading income from net earnings from self-employment. In that view, the salary is funded entirely by income that Congress intended to be outside the self-employment tax and earned income base, and the arrangement functions only to convert excluded income into qualifying compensation.
Until there is a Revenue Ruling, a Technical Advice Memorandum, or other formal published guidance from the IRS, or a Tax Court decision directly addressing this structure, it remains an aggressive but increasingly common practice without clear legal authority in either direction. Tax advisers who recommend this popular position should say so plainly to their clients, document the uncertainty, and explain both the technical risk and the potential application of substance-over-form principles.
Once this position is communicated, it is possible for us to base our strategy on an estimate of the costs vs. the benefits of having a trader take a salary from a corporate trading business.