Federal Business and Entity Taxation - Sole Proprietorships, Partnerships, and Corporations
Federal Business and Entity Taxation - Sole Proprietorships, Partnerships, and Corporations tests who reports income and who pays tax. The exam separates Schedule C income, partnership distributive shares, S corporation pass-through items, and C corporation entity-level tax, then tests basis and owner compensation.
Core rules
- A sole proprietorship is disregarded. The owner reports profit or loss on Schedule C, pays income tax and self-employment tax, and may claim the qualified business income deduction if eligible.
- A partnership files Form 1065 and issues Schedule K-1. It generally pays no entity-level tax. Partners report distributive shares, including separately stated items, and increase basis by income and decrease basis by distributions and losses. Losses are limited by basis, at-risk rules, and passive activity rules.
- A C corporation files Form 1120 and pays the 21% corporate rate. Dividends are not deductible, so earnings can be taxed twice. Reasonable compensation is deductible; excessive compensation may be recharacterized as a dividend.
- An S corporation files Form 1120-S and generally pays no entity-level tax, but shareholders must receive reasonable wages for services before distributions. Eligibility requires, among other things, no more than 100 shareholders, eligible shareholders, and one class of stock.
- Contributions and distributions are basis events. A partner or shareholder generally does not recognize gain on a contribution, but money distributions in excess of basis are taxable.
Worked example
A and B are equal partners. The partnership has $120,000 of ordinary business income. A's outside basis is $10,000 before the year's income. A reports $60,000 on Schedule K-1 and increases basis to $70,000. A then receives a $20,000 cash distribution, reducing basis to $50,000. No gain is recognized because the distribution does not exceed basis. If A had received $80,000, gain would be $10,000. A also pays self-employment tax on the $60,000 share, not on the distribution.
Traps
Do not treat a partner's distributive share as wages or as a guaranteed payment unless the agreement says so. Do not let an S corporation owner take only distributions while performing services. Do not deduct C corporation dividends. Do not forget that distributions reduce basis after income increases it. Do not ignore at-risk and passive loss limits.