Part 2 — Businesses
Part 2 covers how business income is taxed across every common entity — sole proprietorships, partnerships, S corporations, and C corporations — along with the mechanics that cut across all of them: accounting methods, the ordinary-and-necessary expense standard of §162, cost recovery through depreciation, owner basis, payroll and employment taxes, net operating losses, business credits, the qualified business income deduction, and the character of gains on the sale of business property. Learn the entity's tax personality first (who pays the tax and on which return), then layer on the shared computational rules. As in Part 1, figures that Congress indexes each year — the §179 expensing limit and its investment phaseout, the Social Security wage base, the standard mileage rate — should be learned as concepts and confirmed against the current-year instructions, while stable statutory rules (the 20% QBI deduction, the 80%-of-taxable-income NOL limit for post-2017 losses, the 21% corporate rate structure, MACRS recovery periods) are stated as fixed.
Choice of Entity and How Each Is Taxed
The starting question for any business return is which entity is filing and whether it pays its own tax. A sole proprietorship is not a separate taxpayer: the owner reports net profit or loss on Schedule C of the individual Form 1040, and a single-member LLC that has not elected corporate treatment is a 'disregarded entity' taxed the same way. A partnership is a pass-through: it files an information return (Form 1065) and issues a Schedule K-1 to each partner, so income, deductions, and separately stated items flow through and are taxed to the partners whether or not cash is distributed; by default a domestic LLC with two or more members is taxed as a partnership. A C corporation is a separate taxpayer that files Form 1120, pays entity-level tax, and creates double taxation because distributed profits are taxed again to shareholders as dividends. An S corporation is a pass-through that files Form 1120-S, generally avoids entity-level tax, and passes income through to shareholders on their K-1s. S status is not automatic: the corporation must be a domestic corporation with only allowable shareholders (individuals, certain trusts and estates — not partnerships, corporations, or nonresident aliens), no more than 100 shareholders, and only one class of stock (differences in voting rights alone do not violate this), and it elects S status by filing Form 2553. An entity that wants to change its default classification files Form 8832. Corporations and LLCs also provide a key nontax advantage sole proprietorships and general partnerships lack — limited liability for the owners. A husband-and-wife business in a non-community-property state that both materially participate in is a partnership unless they elect qualified joint venture treatment to each file a Schedule C.
Accounting Methods and Periods
A business's method of accounting determines when income and expense are recognized, and it must be applied consistently. Under the cash method, income is recognized when actually or constructively received and expenses when paid; under the accrual method, income is recognized when earned under the all-events test (all events fixing the right to income have occurred and the amount is determinable) and expenses when incurred and economic performance occurs. Historically, a business with inventory as a material income-producing factor and most C corporations had to use the accrual method, but small-business simplifications now let many taxpayers under a gross-receipts threshold (indexed — verify the current amount) use the cash method and avoid inventory accounting and the uniform capitalization rules. The cash method remains generally unavailable to a C corporation (other than qualifying small businesses and personal service corporations) and to a tax shelter. A special matching rule denies an accrual-method business a deduction for an expense owed to a related cash-method party (such as accrued interest to a controlling shareholder) until the related party includes it in income. A business must use a consistent tax year — the required year is often driven by the owners for pass-throughs — and generally needs IRS consent to change either its tax year or its accounting method, filing Form 3115 for a method change. Changing a method produces a §481(a) adjustment that spreads the cumulative catch-up effect (the income or expense that would otherwise be duplicated or omitted) over a transition period rather than bunching it into one year.
Business Income and §162 Ordinary and Necessary Expenses
Section 162 allows a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. 'Ordinary' means common and accepted in the taxpayer's line of business; 'necessary' means helpful and appropriate — not indispensable. Deductible items include wages, rent, supplies, professional fees, and business interest on a loan used in the business. Several limitations recur on the exam. Business meals are generally 50% deductible (documented and not lavish), while business entertainment — such as taking a client to a sporting event — is fully nondeductible after TCJA. A cash-method business that prepays a multi-year expense such as a three-year insurance premium generally must capitalize and deduct it over the period benefited rather than all at once. Start-up and organizational expenditures may be partly deducted in the year business begins (up to a limited amount, phased out for large start-up costs) with the remainder amortized over 180 months. A business that maintains inventory reduces gross receipts by cost of goods sold, computed from beginning inventory plus purchases and production costs minus ending inventory; producers and larger resellers must capitalize additional indirect costs into inventory under the §263A uniform capitalization (UNICAP) rules unless a small-business exception applies. A home office is deductible only if a portion of the home is used regularly and exclusively as the principal place of business (or to meet clients), and the deduction may be figured under the actual-expense method or a simplified square-footage method. Bad debts of an accrual-method business are deductible when they become worthless (a cash-method business generally has no deduction because the income was never taken in), and self-employed taxpayers may deduct vehicle costs using either actual expenses or the standard mileage rate (an indexed figure — verify current year).
Depreciation: MACRS, §179, and Bonus
Capital expenditures are recovered over time rather than deducted immediately, and the Modified Accelerated Cost Recovery System (MACRS) is the default. MACRS assigns each asset a recovery period and method: 5-year property (automobiles, computers, light trucks) and 7-year property (office furniture and fixtures) use a declining-balance method switching to straight-line; nonresidential real property is depreciated straight-line over 39 years and residential rental real property over 27.5 years, both using the mid-month convention. Personal property generally uses the half-year convention (treating all such property as placed in service at the year's midpoint), unless more than 40% of the year's additions occur in the fourth quarter, which triggers the mid-quarter convention. Land is never depreciable. Depreciation is computed and reported on Form 4562. Two acceleration provisions layer on top of MACRS. Section 179 lets a business elect to expense the cost of qualifying tangible property (and certain real-property improvements) in the year placed in service, but the deduction is capped at an annual dollar limit (indexed — verify), is reduced dollar-for-dollar once total qualifying purchases exceed an investment ceiling, and cannot create or increase a business loss (the excess carries forward). Bonus depreciation, by contrast, has no dollar cap and is not limited by business income — it can create a loss — and applies to new and used qualifying property, though the bonus percentage is phasing down under current law. If §179 property drops to 50%-or-less business use before the end of its recovery period, part of the benefit is recaptured as ordinary income. 'Listed property' such as passenger autos is subject to special caps and substantiation rules, and acquired goodwill and other §197 intangibles are amortized straight-line over 15 years regardless of their actual life.
Partnership Taxation and Basis
A partnership is a conduit: it computes ordinary business income and separately states items that could affect partners differently (capital gains, §1231 gains, charitable contributions, credits), then reports them to each partner on Schedule K-1 (Form 1065). A partner's distributive share is taxed to the partner in the partner's tax year that includes the partnership's year-end, regardless of whether cash is distributed, and the tax character of an item (for example, long-term capital gain) is determined at the partnership level and retains that character in the partner's hands. Outside basis — the partner's basis in the partnership interest — is the gatekeeper for deducting losses and receiving tax-free distributions. It begins with cash and the adjusted basis of property contributed, plus the partner's share of partnership liabilities (a feature unique to partnerships: a partner's share of entity debt increases basis, unlike an S corporation shareholder's), and is increased by the partner's share of income and additional contributions, and decreased by distributions and the share of losses and nondeductible expenses. A partner may deduct their share of partnership losses only up to outside basis; losses suspended for lack of basis carry forward until basis is restored. Even if basis exists, the at-risk rules of §465 and the passive activity loss rules of §469 can further defer losses. A cash distribution that exceeds the partner's outside basis produces recognized gain. A guaranteed payment — a fixed payment for services or capital determined without regard to partnership income — is deductible by the partnership and ordinary income to the partner (and, for services, subject to SE tax), differing from a distributive share, which is a share of the partnership's own results. A general partner's distributive share of ordinary trade or business income is generally subject to self-employment tax. A calendar-year partnership files Form 1065 by March 15, and under the centralized (BBA) audit regime, audit adjustments are generally assessed and collected at the partnership level unless the partnership elects out or pushes the adjustments out to the partners.
S Corporation Taxation and Basis
An S corporation passes income and separately stated items through to shareholders on Schedule K-1, allocated on a strict per-share, per-day basis (unlike the flexible special allocations partnerships can make). A shareholder's stock basis is increased by contributions and the share of income (including tax-exempt income) and decreased, in order, first by distributions, then by nondeductible expenses, then by deductible losses and deductions. Losses are deductible only up to the shareholder's stock basis plus any basis in direct loans the shareholder made to the corporation — and, unlike a partner, an S shareholder gets no basis for corporate-level debt to third parties, which is why S owners often cannot deduct losses that partners could. Once stock basis is reduced to zero, further losses reduce debt basis; suspended losses carry forward. Distributions from an S corporation with no accumulated earnings and profits are tax-free returns of capital to the extent of stock basis, with any excess taxed as capital gain; the Accumulated Adjustments Account (AAA) tracks post-election income to determine how distributions are treated when the corporation has E&P from prior C years. Two employment-tax issues dominate the exam. An S shareholder who works in the business must be paid reasonable compensation as W-2 wages subject to payroll tax before taking distributions, because the incentive to understate wages — distributions are not subject to SE or payroll tax — is a frequent IRS audit target. And fringe benefits such as health insurance provided to a more-than-2% shareholder-employee must be included in the shareholder's W-2 wages (though the shareholder may then claim the self-employed health insurance deduction). The built-in gains (BIG) tax is a corporate-level tax imposed on a former C corporation that converts to S status and sells appreciated assets within the recognition period. An S election terminates involuntarily if the corporation ceases to meet the eligibility requirements or has excess passive investment income with accumulated E&P for three consecutive years; after a termination the corporation generally may not re-elect for five years without IRS consent. A calendar-year S corporation files Form 1120-S by March 15.
C Corporation Taxation
A C corporation is a separate taxpayer filing Form 1120 (due, for a calendar-year corporation, on the 15th day of the fourth month), and its earnings are subject to the classic double tax — once at the corporate level and again when distributed to shareholders as dividends. Several C-specific rules recur. The dividends-received deduction (DRD) mitigates a third layer of tax when one corporation owns stock in another: a corporate shareholder owning less than 20% deducts 50% of dividends received, one owning 20% to less than 80% deducts 65%, and one owning 80% or more may deduct 100%. A C corporation's capital losses may offset only capital gains (never ordinary income), carrying back three years and forward five. Its charitable contribution deduction is limited to a percentage of taxable income (with excess carried forward). Two penalty taxes discourage using a corporation to shelter income from shareholders: the accumulated earnings tax applies when a corporation accumulates earnings beyond the reasonable needs of the business to avoid shareholder-level tax on dividends, and the personal holding company tax applies to a closely held corporation with substantial passive income that is not distributed. When a C corporation distributes appreciated property (worth more than its basis) to a shareholder, the corporation recognizes gain as if it had sold the property at fair market value, and the shareholder is treated as receiving a distribution equal to that value. Understanding when income is taxed once versus twice — and how the DRD, capital-loss, and penalty-tax rules bend that framework — is the core of the C corporation material.
Payroll and Employment Taxes
Employers must withhold federal income tax and the employee share of FICA from wages, match the employer share, and deposit and report the tax. FICA has two components: Social Security at 6.2% each on the employee and employer (12.4% combined) up to the annual wage base (indexed — verify), and Medicare at 1.45% each (2.9% combined) with no ceiling; the self-employment tax mirrors this combined structure on net SE earnings. High earners also owe the 0.9% Additional Medicare Tax, withheld by the employer on wages above a set threshold but ultimately reconciled on the individual return, and there is no employer match for it. Federal unemployment tax (FUTA) is paid entirely by the employer (not withheld from employees) on a limited wage base, with a credit for state unemployment taxes paid. Reporting runs on a fixed calendar: Form 941 reports withheld income tax and both shares of FICA quarterly (small employers may file Form 944 annually); Form 940 reports FUTA annually; and Forms W-2 to each employee and W-3 to the Social Security Administration report annual wages and withholding. A business obtains an Employer Identification Number by filing Form SS-4, and deposits withheld income tax and FICA on a monthly or semiweekly schedule determined by its lookback-period liability. Worker classification is decisive: whether a worker is an employee or an independent contractor turns primarily on the degree of behavioral and financial control the business exercises and the relationship of the parties, and misclassifying an employee as a contractor exposes the business to back employment taxes. Payments of $600 or more to an unincorporated independent contractor for services are reported on Form 1099-NEC. Finally, the Trust Fund Recovery Penalty of §6672 lets the IRS assess the unpaid withheld ('trust fund') taxes personally against any responsible person who willfully failed to collect or pay them over — a 100% penalty that pierces the corporate shield.
Net Operating Losses, Business Credits, and the QBI Deduction
A net operating loss (NOL) generally arises when a taxpayer's business deductions exceed income. For NOLs arising in tax years after 2017, the TCJA rules eliminated carrybacks (the loss is carried forward indefinitely) and limited the deduction to 80% of taxable income in the carryforward year — so a post-2017 NOL cannot wipe out more than 80% of a later year's income. For noncorporate taxpayers, the excess business loss limitation of §461(l) caps the business loss that can offset nonbusiness income in a year (with the disallowed amount converting into an NOL carryforward); in computing an individual's NOL, nonbusiness deductions and personal items are generally not allowed to increase the loss. General business credits — the research credit, work opportunity credit, disabled access credit, small employer pension plan startup credit, and others — are combined and limited to the taxpayer's tax (reduced by certain other credits); the Work Opportunity Tax Credit rewards hiring workers from targeted groups, and the research credit rewards increases in qualified research expenditures. A general business credit that exceeds the current-year limitation is carried back one year and forward twenty. Section 199A allows eligible owners of pass-through businesses (sole proprietorships, partnerships, S corporations) to deduct up to 20% of qualified business income — a stable statutory percentage — subject, above an income threshold, to limitations based on W-2 wages and the unadjusted basis of qualified property and to a phaseout for specified service businesses. The QBI deduction is taken by the owner on the individual return, does not reduce SE tax, and is available whether the owner itemizes or takes the standard deduction.
Property Dispositions: §1231, §1245, and §1250
The sale of business property is governed by a set of characterization rules that can turn what looks like ordinary income into capital gain and vice versa. Section 1231 property is depreciable property and real property used in a trade or business and held more than one year. The favorable §1231 rule nets all §1231 gains and losses for the year: a net §1231 gain is treated as long-term capital gain (preferential rates), while a net §1231 loss is treated as an ordinary loss (fully deductible against ordinary income) — the best of both worlds, subject only to a five-year lookback that recharacterizes gain as ordinary to the extent of unrecaptured §1231 losses deducted in the prior five years. Depreciation recapture then overlays §1231. Under §1245, when depreciable personal property (equipment, machinery) is sold at a gain, the gain is recharacterized as ordinary income to the extent of all depreciation previously claimed, with any remaining gain treated as §1231 gain. Under §1250, for real property, only depreciation taken in excess of straight-line is recaptured as ordinary income — and because MACRS real property uses straight-line, there is usually no §1250 recapture; instead, the portion of an individual's gain attributable to straight-line depreciation on real property is 'unrecaptured §1250 gain,' taxed at a maximum 25% rate. The practical sequence for a business asset sold at a gain is therefore: apply §1245 or §1250 recapture first to convert some gain to ordinary income, then treat the remainder as §1231 gain that nets with other §1231 items. This interplay is a favorite exam topic because it determines both the amount and the rate of tax on the disposition of business assets.
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