Businesses
Entity and business income concepts
Classify the entity first: sole proprietorship, partnership, S corporation, C corporation, or disregarded entity. Formation generally avoids gain under the corporate contribution rules or partnership contribution rules, but liabilities and boot can trigger gain. Basis is central: owner basis limits deductible losses; S corporation shareholders have stock basis and debt basis, while partners have outside basis that includes a share of partnership liabilities. Distributions are tax-free only to the extent of basis, with special rules for S corporations and partnerships.
Know the tax differences. Partnerships file Form 1065 and issue Schedules K-1; guaranteed payments are ordinary income to the partner and deductible to the partnership, and partners pay self-employment tax on distributive shares in many cases. S corporations require eligible shareholders, a single class of stock, and reasonable compensation for shareholder-employees before distributions. C corporations face double taxation, E&P, and constructive dividend risk. Account for depreciation, §179, bonus depreciation, QBI, accounting methods, inventory, NOLs, payroll taxes, retirement plans, and estimated taxes.
Traps: treating S corporation distributions as wages; ignoring basis and at-risk limits; passive activity losses; personal use of company assets; capitalizing repairs; accrued expenses paid to related cash-basis parties; and misclassifying workers.
Worked example: An S corporation shareholder has $10,000 stock basis and receives a $25,000 distribution. The first $10,000 is a tax-free return of basis; the excess $15,000 is generally taxable gain. Rule of thumb: an owner who works in an S corporation must take reasonable salary-distributions are not a substitute for payroll.