Part 2: Businesses
Part 2 tests the taxation of business entities: sole proprietorships, partnerships, corporations, and S corporations, along with accounting methods, business income and expenses, depreciation, and payroll taxes. This chapter reviews how each entity is taxed.
Entity Types and How They Are Taxed
A sole proprietorship reports business income on the owner's individual return (Schedule C) and is not a separate taxpayer. A partnership is a pass-through entity: it files an information return (Form 1065) and issues Schedule K-1s, so income and deductions flow through to the partners. A C corporation is a separate taxpayer that pays entity-level tax, and its distributed profits are taxed again to shareholders as dividends, producing double taxation. An S corporation is a pass-through that generally avoids entity-level tax, with income reported by shareholders on their own returns.
Accounting Methods and Periods
Under the cash method, income is recognized when received and expenses when paid; under the accrual method, income is recognized when earned and expenses when incurred, following the all-events test. Many larger businesses and those carrying inventory historically had to use the accrual method, though small-business simplifications now allow more taxpayers to use the cash method. A business must use a consistent tax year and generally needs IRS consent to change its accounting method by filing the required form.
Business Income, Expenses, and Depreciation
Ordinary and necessary business expenses are deductible; capital expenditures must generally be recovered over time through depreciation. The Modified Accelerated Cost Recovery System (MACRS) is the standard depreciation method, and provisions such as Section 179 expensing and bonus depreciation allow accelerated write-offs within limits. Some costs, such as most business meals, are only partially deductible, and expenses that are personal or lavish are disallowed.
Employment Taxes
Employers must withhold income tax and the employee share of Social Security and Medicare (FICA) taxes from wages, pay the matching employer share, and remit federal unemployment (FUTA) tax. Payroll returns such as Form 941 report withholding, and Forms W-2 and W-3 report annual wages. Misclassifying an employee as an independent contractor can create significant employment-tax liability, so worker classification is closely examined.