Tax Compliance and Planning for Entities
Domain 2: Tax Compliance and Planning for Entities
Entity questions test whether you can trace one dollar of business income through the return and onto the owner's Form 1040 with the right character and the right payroll consequences. S corporations, partnerships, and C corporations dominate, and basis with distribution ordering does most of the damage.
S corporation fundamentals
- Eligibility: no more than 100 eligible shareholders, one class of stock, an eligible domestic corporation; an ineligible election is ineffective or terminates the election.
- Entity-level taxes are limited but real: built-in gains tax at 21% on asset sales within five years of conversion, excess net passive income tax, and LIFO recapture.
- Income increases stock basis; distributions reduce it but are tax-free only to the extent of basis. Excess distributions are capital gain, and losses above basis are suspended.
- A shareholder-employee must take reasonable compensation; distributions are not wages and carry no FICA.
Partnerships
- Partners take a distributive share and add their share of liabilities to basis, which permits loss deductions and tax-free cash distributions.
- §704(b) substantial economic effect governs special allocations; §704(c) allocates built-in gain or loss on contributed property back to the contributing partner.
- Guaranteed payments for services or capital are ordinary income, deductible to the partnership, and generally subject to self-employment tax.
- A §754 election creates an inside basis step-up for a transferee partner or on a partner's death.
C corporations and owner compensation
- The 21% corporate rate plus shareholder-level tax at 0/15/20% (and 3.8% NIIT) is the double tax planners try to avoid.
- The accumulated earnings tax and the personal holding company tax each apply a 20% penalty rate to undistributed or unreasonably accumulated income.
- §1202 can exclude gain on qualified small business stock held five years, limited to the greater of $10 million (indexed; roughly $15 million for recent issuances) or 10 times basis.
Worked example
An S corporation earns $200,000 before paying its sole shareholder, who performs all the services. A $90,000 salary is defensible and the $110,000 balance is distributed. Payroll tax at 15.3% on $90,000 is $13,770 (the 2025 Social Security wage base of $176,100 is not reached). Had the IRS recharacterized the full $200,000 as wages, payroll tax would be $30,600 - $16,830 more. The salary must survive a facts-and-circumstances test of duties, time devoted, training, and dividend history.
Traps that cost marks
- Reversing basis ordering: income increases basis before distributions are measured.
- Treating a shareholder guarantee of a corporate loan as debt basis; only actual economic outlay creates it.
- Assuming a limited partner's distributive share is subject to self-employment tax.
- Overlooking the five-year built-in gains window when an S corporation sells appreciated assets.