Taxation of non-resident proprietary traders

L

lescor

This subject has been covered before, but there is a new tax preparation company on this site and I'd like to hear their input on this subject.

Are traders who are members of a US based LLC proprietary trading firm, and who receive a K1 form at year end, required to file a US tax return?

I don't mean retail direct access traders, or W8 forms or any of that, just prop traders in an LLC.

What's the difference between active and passive income with an LLC? If one is a different class member of the partnership than the owners/operators, and has no hand in running the business, how does the IRS view the trader as being connected to the partnership? If the trader has no SSN or taxpayer ID number, how would the IRS even know that you should file a return, how would they track you down? What happens if you don't file? What if you have a loss, how would you be able to claim that against anything?

There is a lot of confusion on this subject among the traders I talk to who are in this situation. Any help or first hand experience would be appreciated.
 
While I'm not sure whether you need to file an informational return, taxation depends on whether you are a citizen of the US.

While US citzens are taxed on thier worldwide income, citizens of most other countries aren't. Most countries tax based on residency.
 
Stand by. I'm aware of the original posting. There are many complicated issues, exceptions and qualifications involved in the questions presented. I've got some major projects I am dealing with at the moment, and as soon as I can clear them off my desk, I'll post a further response. I'm not ignoring the original question that launched this thread.
 
The complex part of your question is the tax treatment of non-residents. The reasons it is so complex are that the rules vary based upon (a) the number of days, if any, that the trader spends in the U.S.; (b) whether the person has a green card; (c) whether the trader is trading in his own name or through an entity.

It would take many pages to completely address the nonresidency issues of your question, and that is really beyond the intended scope of a Forum such as this. Let me tell you the general rules, recognizing that there may be exceptions and qualifications that could eviscerate the general rule in any given circumstance—and perhaps even in your circumstance.

Here’s the general rule: You are going to be taxed by the U.S. on the income allocated to you on the K-1 you get from the proprietary trading firm, the LLC. You have to file a U.S. income tax return, a Form 1040NR. You have to pay income tax on that allocated income. The good news, if any, is that you don’t have to pay state income tax assuming you are not a resident of that state.

The bottom line here is that this type of question (taxation of nonresidents engaged in proprietary trading) does not readily lend itself to short, blithe answers. Given all the rules, exceptions, qualifications, and exceptions to the exceptions, there really is no substitute for a one-on-one consultation with an expert who can then address your specific, individualized facts and provide you with a focused opinion.

This may be why it appears there may be confusion among nonresidents about the law. Perhaps it is because each of them has different fact patterns and hence there are different answers to each of them.

You also asked how the IRS would know if the taxes were not paid. I’d be surprised if the LLC allowed you to become a member without a SSN or taxpayer ID number. But if they do, that situation still does not exempt you from compliance with the Code. The IRS could find out by auditing the LLC, by a tipster, a disgruntled former spouse, a disgruntled former lover, a disgruntled former business partner . . . the usual suspects.

The active vs. passive treatment is described in IRS FSA 200111001. Here’s a general summary of the rules: The determination whether expenses are “business expenses” is made at the LLC level. Hence a “business expense” created at the LLC level retains that same characterization when it flows through to the members/partners, regardless of whether the partner in question is active or passive. Active members can deduct their allocated share of business expenses.

But there is a different rule for passive members. They fall victim to the Passive Activity Loss (PAL) rules of I.R.C. § 469. As a general rule, PAL losses are deductible only to the extent of passive activity income. If there is insufficient passive activity income to completely offset against the PAL, then the unused portion of the PAL carries forward to the succeeding tax year.

And then there’s an exception to all that for “investment interest” for passive members, i.e., margin interest expense. A passive member will be limited in his or her ability to deduct margin interest. The limit is that the deduction for margin interest is limited to the amount of “investment income.” That term has a technical meaning, so it is probably a smaller amount than most people might realize.

I regret that I cannot provide a short, crisp two paragraph answer to this post. But the questions invoke very complicated topics for which there are not simple answers.
 
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