Entity Types — Big Picture Overview
| Feature | Sole Prop | Partnership | C Corp | S Corp |
|---|
| Return | Sch C | Form 1065 | Form 1120 | Form 1120-S |
| Tax level | Owner | Partners | Entity + owner | Owners only |
| Liability protection | None | Varies | Full | Full |
| IPO eligible | No | No | Yes | No |
| SE tax on profits | Yes | GP: Yes | No (wages only) | No (wages only) |
| Max shareholders | 1 | Unlimited | Unlimited | 100 |
Flow-through entities: Sole Prop, Partnership, LLC, S Corp — income passes to owners; no entity-level federal tax.
C Corp only = double taxation (entity pays 21%, then shareholders pay on dividends).
Double Taxation — C Corporations
Layer 1:Corp pays 21% flat tax on taxable income
Layer 2:Shareholders pay on dividends received (0/15/20% + 3.8% NIIT)
Result:Same earnings taxed TWICE
Mitigation Strategies (reduces but does NOT eliminate):
- Pay reasonable salaries to shareholder-employees → deductible by corp
- Lease property back from shareholders → rent is deductible
- Charge interest on shareholder loans → deductible interest
- Dividends Received Deduction (DRD) → corporate shareholders get 50/65/100%
ONLY complete elimination: Elect S corporation status → removes entity-level tax entirely.
Trap: TCJA reduced rate to 21% but did NOT eliminate double taxation.
Check-the-Box (CTB) Regulations
Default Classifications:
| Entity | Default Tax Treatment | Can Elect |
|---|
| Single-member LLC | Disregarded entity (Sch C) | C corp (Form 8832) |
| Multi-member LLC | Partnership (Form 1065) | C corp (Form 8832) |
| General partnership | Partnership | C corp (Form 8832) |
| Limited partnership | Partnership | C corp (Form 8832) |
| Corporation (formed by filing) | C corp (cannot opt out) | S corp (Form 2553) |
Any unincorporated entity can elect C corp treatment via Form 8832. Then can further elect S corp via Form 2553.
SMLLC ≠ partnership. Single-member LLC = disregarded entity (sole proprietor). Multi-member LLC = partnership by default.
Sole Proprietorship — Key Rules
- NOT a separate legal entity from its owner → unlimited personal liability
- Income on Schedule C of Form 1040
- Must use same tax year as the proprietor
- Minimal cost and time to organize (greatest nontax benefit)
- All net profit is self-employment income → subject to SE tax
- Cannot issue stock → cannot go public
- Ceases to exist if owner dies or stops operating
Self-Employment Tax:
SE income × 0.9235= Net SE earnings
Net SE × 15.3%= SE tax (up to $176,100 wage base)
Net SE × 2.9%= Additional Medicare above $176,100
Deduct 50% of SE tax→ above-the-line deduction (AGI)
Entity Selection — Tax & Nontax Factors
Tax Factors
- Level of taxation (single vs. double)
- SE tax exposure
- QBI deduction eligibility (flow-through only)
- Ability to deduct early losses
- Preferred tax rates on distributions
- Tax year flexibility
Nontax Factors
- Liability protection
- Cost and time to organize
- Capital raising ability (IPO)
- Management flexibility
- Ability to transfer ownership
- Number of owners allowed
Best for early losses: Flow-through (S corp/partnership) — losses pass to owners immediately to offset other income. C corp losses are trapped as NOL carryforwards at the entity level.
Best for IPO / going public: C corporation always.
QBI Deduction & NIIT
Qualified Business Income (QBI) Deduction — §199A:
- Deduct up to 20% of QBI from flow-through entities
- Below-the-line deduction (from AGI, not for AGI)
- NOT available for C corporations
- NOT available for SSTBs (Specified Service Trades or Businesses) above income thresholds: law, accounting, health, consulting, financial services, etc.
Net Investment Income Tax (NIIT) — 3.8%:
- Applies when MAGI exceeds $250,000 (MFJ) / $200,000 (Single)
- Passive income from S corps and partnerships = investment income for NIIT
- Active S corp wages = NOT investment income
- C corp dividends = investment income subject to NIIT
Tax Year Rules by Entity
| Entity | Required Tax Year | Exception |
|---|
| Sole proprietorship | Same as individual (calendar) | None |
| C corporation | Any fiscal year | Personal service corps → calendar year required |
| S corporation | Calendar year required | Business purpose or §444 election with deposit |
| Partnership | Same as majority partners | Business purpose or §444 election with deposit |
FALSE: All taxpayers must use a calendar year. C corps can freely use fiscal years. Sole props must match their owner. Partnerships/S corps must match majority partners/shareholders or have business purpose.
§444 election allows a different year but requires interest payment (like a deposit to IRS) to compensate for tax deferral.
S Corporation — Eligibility Requirements
Shareholder Rules
- ≤ 100 shareholders max
- Family members count as ONE shareholder
- Must be individuals, estates, or certain trusts
- NO corporations or partnerships as shareholders
- Must be US citizens or residents
Corporate Rules
- Must be a domestic corporation
- Only ONE class of stock
- Voting differences are OK (no different economic rights)
- Cannot be an ineligible corp type (financial inst., insurance, etc.)
If ANY requirement is violated → S election terminates on the date of failure. Must re-elect after 5-year waiting period (unless IRS consents earlier).
Corporate Tax Formula vs. Individuals
| Item | Individual | C Corporation |
|---|
| AGI concept | Yes — above-the-line deductions | NO AGI |
| Standard deduction | Yes ($13,850 single) | None |
| Personal exemption | None (suspended) | None |
| Tax rates | Graduated (10–37%) | Flat 21% |
| Capital loss deduction | Up to $3,000/yr vs ordinary | Zero vs ordinary |
| QBI deduction | Yes (flow-through) | None |
| Start with | Gross income | Book income → BTD adjustments |
Deduction Sequencing (Corps): (1) All other deductions → (2) Charitable contributions (10% limit) → (3) DRD → (4) NOL deduction
Book-Tax Differences (BTD) — Framework
| Type | Definition | Creates |
|---|
| Permanent | Never reverses (structural tax rule) | Permanent gap between book and taxable income |
| Temporary | Timing difference — will reverse in future years | Deferred tax asset or liability on balance sheet |
| Favorable | Tax income < book income → lower tax now | Deferred tax liability (pay more later) |
| Unfavorable | Tax income > book income → more tax now | Deferred tax asset (pay less later) |
Formula: Start with book income → subtract favorable BTDs → add back unfavorable BTDs = Taxable income
Included in book but excluded from tax = Favorable permanent BTD (e.g., muni bond interest). Deductible for tax but not book = Favorable temporary BTD (e.g., accelerated depreciation).
Common BTD Examples
| Item | Book | Tax | Type |
|---|
| Municipal bond interest | Income | Excluded | Permanent Favorable |
| Life insurance premiums | Expense | Non-deductible | Permanent Unfavorable |
| Life insurance death benefit | Income | Excluded | Permanent Favorable |
| Meals & entertainment | 100% expense | 50% deductible | Permanent Unfavorable |
| Fines & penalties | Expense | Non-deductible | Permanent Unfavorable |
| MACRS vs straight-line depreciation | SL (less) | MACRS (more) | Temporary Favorable |
| Unearned rent received | Liability (deferred) | Taxed immediately | Temporary Unfavorable |
| Net capital loss (NCL) | Deducted now | Carried back/forward | Temporary Unfavorable |
| Goodwill (asset acquisition) | Impairment only | 15-yr §197 amortization | Temporary Favorable |
| Goodwill (stock acquisition) | Impairment expense | Not deductible | Permanent Unfavorable |
Dividends Received Deduction (DRD)
| Corp Ownership % in Payer | DRD % | Taxable % | Effective Rate |
|---|
| < 20% | 50% | 50% | 10.5% |
| 20% – 79% | 65% | 35% | 7.35% |
| ≥ 80% | 100% | 0% | 0% |
Purpose: Mitigate triple taxation when corporate earnings pass through multiple corporate layers.
DRD Taxable Income Limitation: DRD cannot exceed 50% (or 65%) of the corporation's taxable income computed WITHOUT the DRD. BUT — if allowing the full DRD would CREATE or INCREASE an NOL, the limitation does NOT apply (full DRD allowed).
DRD is available only to corporate shareholders, not individual shareholders.
NCL and NOL — Corporate Rules
Net Capital Loss (NCL)
- Corps CANNOT deduct NCL against ordinary income (individuals can deduct $3,000/yr)
- Carry BACK 3 years
- Carry FORWARD 5 years
- Must be used as short-term capital loss when carried
- Creates unfavorable temporary BTD in year of loss
- Creates favorable temporary BTD when used
Net Operating Loss (NOL)
- Carry forward indefinitely (post-TCJA)
- Limited to 80% of taxable income in carryforward year
- No carryback (post-TCJA, general rule)
- Creates unfavorable temporary BTD when incurred
- Creates favorable BTD when used
- C corp NOLs do NOT transfer to S corp years
§197 Goodwill — Asset vs. Stock Acquisition
| Feature | Asset Acquisition | Stock Acquisition |
|---|
| Tax basis in assets | FMV (stepped up) | Carryover basis (no step-up) |
| Goodwill tax treatment | §197: amortize over 15 yrs | Not amortizable |
| Depreciation | Restart at FMV | Continue existing schedules |
| Liabilities assumed | Buyer chooses | Inherits ALL (known + unknown) |
| NOL carryovers | Not transferred | Transfer (§382 limit applies) |
| BTD: Goodwill | Favorable temporary (tax deduction > book) | Permanent unfavorable (impairment not deductible) |
Buyer prefers asset deals (stepped-up basis, §197 amortization). Seller prefers stock deals (capital gains rates, no double tax on built-in gains).
Charitable Contributions — Corporate Rules
- Limit: 10% of taxable income computed before the charitable deduction, DRD, and NOL deduction
- Excess contributions carry forward 5 years
- Property donations: deduct FMV (long-term capital gain property) or adjusted basis (ordinary income property)
Deduction Sequencing Order (Corporations):
Step 1All other deductions (wages, depreciation, interest, etc.)
Step 2Charitable contributions (10% of pre-charity taxable income)
Step 3Dividends Received Deduction (50%, 65%, or 100%)
Step 4NOL deduction (80% of taxable income limit)
The sequencing matters for limits — compute charitable limit before applying DRD and NOL.
§301 Distribution Waterfall — 3 Buckets
Bucket 1: Dividend IncomeTo extent of Current E&P + Accumulated E&P
Bucket 2: Return of CapitalExcess over E&P → reduces shareholder's stock basis (tax-free)
Bucket 3: Capital GainExcess over both E&P AND stock basis → capital gain to shareholder
Current E&P applies first to distributions during the year (pro rata). Accumulated E&P applied in order of distributions. A deficit in accumulated E&P does NOT offset current E&P.
To be a dividend: Must have E&P. If E&P = $0, distribution is return of capital first, then capital gain. Cannot be a qualified dividend if no E&P.
E&P vs. Retained Earnings
| Item | E&P Adjustment |
|---|
| Federal income tax paid | REDUCES E&P (not deducted for book) |
| DRD | NOT allowed for E&P (add back) |
| MACRS depreciation | Use straight-line for E&P (slower) |
| §1245 recapture income | Increases E&P |
| Net capital loss | Reduces E&P when incurred (not when carried) |
| Noncash distribution | Reduced by FMV of property distributed |
| Stock distributions (tax-free) | No E&P reduction |
FALSE: E&P = Retained Earnings. E&P is a tax concept with different adjustments. Retained earnings is GAAP. They diverge significantly.
Noncash Property Distributions — Rules
Corporation Level:
- Corp recognizes GAIN as if it sold property at FMV on distribution date
- Corp does NOT recognize losses on nonliquidating distributions
- Gain increases E&P BEFORE computing the dividend amount
- E&P then reduced by FMV of property distributed
Shareholder Level:
- Amount received = FMV of property
- Basis in received property = FMV (regardless of corp's basis)
- Characterized as dividend/return of capital/capital gain per the waterfall
KEY ASYMMETRY: Corp recognizes gains BUT NOT losses on nonliquidating distributions. In liquidations, losses CAN be recognized (with anti-stuffing exceptions).
Constructive Dividends
The IRS can recharacterize transactions as dividends when they economically benefit shareholders but are disguised as something else.
Common Constructive Dividend Situations:
- Excessive compensation to shareholder-employees (unreasonable salary)
- Below-market loans from corp to shareholder
- Corp pays shareholder's personal expenses
- Corp pays rent on shareholder's personal property (above market)
- Corp pays shareholder's personal liabilities
- Bargain sales of corp property to shareholders
Result: Taxable to shareholder as ordinary income (or qualified dividend if criteria met) BUT NOT deductible to the corporation. Worst of both worlds. IRS targets closely-held C corps most aggressively.
Stock Distributions & Liquidations
Stock Distributions:
- Generally tax-free to shareholders (§305 general rule)
- Exceptions (taxable): cash/stock option distributions, disproportionate distributions, certain convertible preferred distributions
- Stock basis is allocated between old shares and new shares based on FMV
Corporate Liquidations — §331:
- Shareholder: treated as sale of stock → gain/loss = FMV received − stock basis → usually capital gain
- Basis in property received: FMV on distribution date (§334(a))
- Corporation: recognizes gain/loss as if sold at FMV (losses may be disallowed — related party / anti-stuffing)
- §332 Exception: 80%+ corporate parent → NO gain/loss at either level; carryover basis
§351 — Three Requirements for Tax Deferral
1. PROPERTY
- Money, tangible, intangible assets qualify
- Services do NOT qualify
- Services + property OK if property ≥ 10% of services FMV
- Investment companies excluded
2. STOCK ONLY
- Must receive ONLY stock in exchange
- Boot (cash, notes, property) → triggers gain recognition
- Losses are NEVER recognized
- All stock classes OK (common, preferred, voting, non-voting)
3. CONTROL ≥80%
- ≥80% voting power of ALL voting stock
- ≥80% of all other classes of non-voting stock
- Measured IMMEDIATELY after exchange
- Simultaneous transfers not required
Control test is TWO-PRONGED: 80% voting stock AND 80% all other classes. Failing either prong means the transaction is fully taxable!
§351 — 5-Step Framework
Step 1REALIZED GAIN: FMV(stock) + Boot + Liability relief − Adjusted basis
Step 2RECOGNIZED GAIN: LESSER of Realized gain OR FMV of boot received
Note:Losses are NEVER recognized. Boot includes cash, notes, non-stock property.
Step 3UNRECOGNIZED GAIN = Step 1 − Step 2
Step 4CHARACTER of gain = follows type of property transferred (capital/ordinary/§1231)
Step 5ASH STOCK BASIS: Old basis + Gain recognized − Boot received − Liability relief
Shortcut:FMV of stock − Unrecognized gain
Step 5BCORP ASSET BASIS: Shareholder's old basis + Gain recognized by SH
§357 — Liability Assumption Rules
General Rule (§357(a))Liability relief is NOT boot → no gain triggered
Exception 1 — §357(b)Tax avoidance purpose OR personal liability → ALL liability relief = boot
§357(b) supersedes §357(c) if both triggered
Exception 2 — §357(c)Liabilities EXCEED total basis of all property → EXCESS = boot
Recognized gain = Liabilities − Total basis of ALL property
§357(c) applies per transferor across ALL property contributed. Add up all liabilities and all bases. Only the net excess is boot.
Liability relief IS included in Amount Realized (Step 1) even when it is NOT boot. Don't confuse "not boot" with "not in amount realized."
§357(c) — Worked Problem
Facts: SH contributes property (basis $30,000, FMV $100,000) with $40,000 mortgage. Receives only stock.
Stock FMV = $100,000 − $40,000= $60,000
Amount realized = $60,000 + $40,000 liability= $100,000
Realized gain = $100,000 − $30,000= $70,000
§357(c) applies: $40,000 > $30,000
Excess = boot = $40,000 − $30,000= $10,000
Recognized gain= $10,000
Unrecognized gain = $70,000 − $10,000= $60,000
SH Stock Basis (shortcut): $60,000 − $60,000= $0
Traditional: $30,000 + $10,000 − $0 − $40,000= $0 ✓
Corp asset basis: $30,000 + $10,000= $40,000
HANDOUT EXAMPLE — Step 1 & 2
Facts: SH contributes land (FMV $140,000, basis $40,000), $10,000 liability attached. Receives stock (FMV $120,000) + promissory note (FMV $10,000).
STEP 1 — Amount Realized:
Stock FMV$120,000
Boot (note)$10,000
Liability relief$10,000
Less: Adjusted basis($40,000)
Realized Gain$100,000
STEP 2 — Recognized Gain:
FMV of boot (note only*)$10,000
Realized gain$100,000
LESSER = Recognized gain$10,000
*Liability $10,000 is NOT boot — doesn't exceed basis ($40,000); no tax avoidance → §357 general rule applies.
HANDOUT EXAMPLE — Steps 3, 4, 5
Continuing: Basis $40,000 | Realized gain $100,000 | Recognized $10,000 | Note $10,000 | Liability $10,000 | Stock FMV $120,000
STEP 3 — Unrecognized Gain:
$100,000 − $10,000= $90,000
STEP 4 — Character:Capital gain (land = capital asset)
STEP 5A — SH Stock Basis (Traditional):
Old basis$40,000
+ Gain recognized+$10,000
− Boot received (note)−$10,000
− Liability relief−$10,000
Stock basis= $30,000
Shortcut check: $120,000 − $90,000= $30,000 ✓
STEP 5B — Corp Asset Basis:$40,000 + $10,000 = $50,000
KAHOOT EXAMPLE — §351 with Boot
Facts: Transfer property (basis $20,000, FMV $31,000) for 100% of corp. Receive: stock (FMV $16,000) + $10,000 cash + corp assumes $5,000 mortgage.
Amount realized: $16,000 + $10,000 + $5,000= $31,000
Realized gain: $31,000 − $20,000= $11,000
§357 check: Liability $5,000 < Basis $20,000 → NOT boot
Boot = cash only= $10,000
Recognized = lesser of $11,000 or $10,000= $10,000
Unrecognized gain: $11,000 − $10,000= $1,000
SH stock basis (shortcut): $16,000 − $1,000= $15,000
Traditional: $20,000 + $10,000 − $10,000 − $5,000= $15,000 ✓
Corp asset basis: $20,000 + $10,000= $30,000
Boot Rules — Key Principles
- Boot = any consideration other than stock of the transferee corp (cash, notes, other property)
- Recognized gain = LESSER of realized gain OR FMV of boot (never more than realized gain)
- Losses are NEVER recognized in §351 transactions, even if boot is received
- Boot itself takes FMV as its basis in the hands of the recipient
- Boot received by shareholder → reduces stock basis
What IS boot?
- Cash payments ✓
- Promissory notes / debt instruments ✓
- Other property received from corp ✓
- Excess liabilities under §357(c) ✓
- All liability relief under §357(b) (tax avoidance) ✓
What is NOT boot?
- Liability relief under §357 general rule (liabilities ≤ basis, no avoidance) ✗
§1244 Stock — Ordinary Loss Deduction
Purpose: Encourages investment in small businesses by allowing ordinary loss (instead of capital loss) on worthless stock.
Qualification Requirements:
- Stock issued by a domestic small business corporation
- Stock issued for money or property (not services)
- At time of issuance, corp's aggregate capital ≤ $1,000,000
- Stock must be held by the original issuer (cannot be purchased from another shareholder)
Ordinary Loss Limits:
- $50,000 per year for single filers
- $100,000 per year for married filing jointly
- Excess loss is treated as a capital loss
Gain on §1244 stock is still capital gain — only the loss gets ordinary treatment.
§351 — Character of Gain & Property Types
| Property Transferred | Character of Recognized Gain |
|---|
| Capital asset (land, investment securities) | Capital gain (LTCG if held >1 year) |
| Inventory / accounts receivable | Ordinary income |
| Depreciable §1231 property | Ordinary income (§1245 recapture first), then §1231 |
| Personal use property | Capital gain |
The character "follows the property" — look at what was contributed, then apply the same character rules that would apply if the property had been SOLD outright.
Depreciation recapture: If depreciable personal property is transferred, §1245 recapture is recognized as ordinary income first, then any excess may be §1231 gain — even in a §351 exchange. §1250 recapture also applies to real property.
Taxable Acquisitions — Asset vs. Stock
| Feature | Asset Acquisition | Stock Acquisition |
|---|
| Buyer's asset basis | FMV (stepped up) | Carryover (no step-up) |
| Goodwill | §197: 15-yr amortization | No deduction (book impairment only) |
| Depreciation restart | Yes — at FMV | No — continue existing schedule |
| Hidden liabilities | Buyer can exclude | Buyer assumes ALL |
| NOL transfer | Not transferred to buyer | Transferred (§382 annual limit) |
| Seller preference | Usually no (double tax risk) | Yes (capital gains, single tax layer) |
| Buyer preference | Yes (step-up, §197) | Sometimes (§338 election, speed) |
§351 — Services vs. Property
Services are NOT property under §351.
| Scenario | Result |
|---|
| Contributes services only | Transaction EXCLUDED from §351 → ordinary income = FMV of stock received |
| Contributes property only | Qualifies if control test met; no gain/loss (unless boot) |
| Contributes services + property (property FMV ≥ 10% of services FMV) | QUALIFIES for §351 on property portion; still recognize ordinary income for services |
| Contributes services + property (property <10% of services FMV) | Property deemed "relatively small value" → EXCLUDED; all ordinary income |
Always recognize income for services — §351 defers only the property portion. Service income is always ordinary income regardless.
§721 — Partnership Formation Nonrecognition
- Under §721, no gain or loss is recognized when property is contributed to a partnership in exchange for a partnership interest
- No control requirement (unlike §351 for corporations)
- Partnership takes a carryover basis in contributed property
- Partner's outside basis = adjusted basis of property contributed (not FMV)
Exceptions — gain IS recognized:
- Services contributed for a capital interest → ordinary income = FMV of interest received
- §752(b) deemed distribution: If partnership assumes partner's debt and deemed cash distribution exceeds partner's outside basis → gain recognized
- Investment companies: special rules may trigger gain
§721 allows both gains AND losses to be deferred (unlike §351 which only defers gains).
Capital Interest vs. Profits Interest
| Type | Definition | Tax Treatment to Recipient |
|---|
| Capital Interest | Right to share in liquidation proceeds if partnership immediately liquidated | Ordinary income = FMV of interest received; Outside basis = FMV recognized |
| Profits Interest | Only future profits — zero current liquidation value | NO income recognized (Rev. Proc. 93-27); Outside basis = $0 |
Key test: If the partner left today and the partnership liquidated, would they receive anything? Yes → capital interest (taxable). No → profits interest (not taxable).
FALSE: Partners who receive profits interests must recognize ordinary income. → ONLY capital interests trigger income recognition.
Outside Basis — Calculation & Adjustments
Initial Outside Basis:
+ Cash contributed
+ Adjusted basis of property contributed
+ Share of recourse debt (economic risk of loss)
+ Share of nonrecourse debt (profit-sharing ratio)
− Debt relief (liability assumed by partnership = deemed cash distribution)
Annual Basis Adjustments (in ORDER):
1st: + Income / gain items
2nd: − Distributions
3rd: − Losses / deductions (limited to basis; cannot go below zero)
Order matters: Positive adjustments FIRST, then distributions, then losses. NOT the reverse.
Debt Allocation — Recourse vs. Nonrecourse
| Debt Type | Allocated To | Effect |
|---|
| Recourse | Partners who bear economic risk of loss (typically general partners) | Increases those partners' outside basis |
| Nonrecourse | All partners based on profit-sharing ratios | Increases all partners' outside basis proportionally |
Partnership Assumes Partner's Liability:
- Treated as a deemed cash distribution to the contributing partner (§752(b))
- Reduces that partner's outside basis
- If deemed distribution exceeds outside basis → gain recognized
S corp difference: S corp shareholders CANNOT include S corp debt in stock basis. Partners CAN include their share of ALL partnership debt in outside basis. This makes partnerships more useful for loss-generating ventures.
Separately Stated Items vs. Ordinary Income
Separately stated items = items that could affect different partners' taxes differently based on their individual circumstances.
| Separately Stated (K-1) | Ordinary Business Income |
|---|
| Net long-term capital gains/losses | Sales revenue |
| Net short-term capital gains/losses | Cost of goods sold |
| §1231 gains/losses | Business depreciation |
| Charitable contributions | Employee salaries/wages |
| Qualified dividends | Business interest expense |
| Foreign tax credits | Guaranteed payments (deducted here) |
| Investment interest expense | Rent from business property |
Character is determined at the partnership level, then retains that character when flowing through to partners.
Guaranteed Payments
Guaranteed payments = fixed amounts paid to partners for services or capital use, regardless of partnership income.
To the Receiving Partner:
- Ordinary income
- Self-employment income (always)
- Shown on Schedule K-1 as separately stated item
- Basis is increased by the guaranteed payment income
To the Partnership:
- Deducted in computing ordinary business income
- NOT the same as salary (no payroll taxes)
- Always separately stated on K-1
Guaranteed payments are BOTH: included in ordinary income computation (as a deduction) AND separately stated on K-1. They occupy a unique dual position.
Partnership Holding Period & Reporting
Holding Period of Partnership Interest:
| Property Contributed | Holding Period of Interest |
|---|
| Capital asset or §1231 asset | TACKS — carries over from original acquisition date |
| Ordinary income property (inventory, A/R) | Starts fresh on contribution date |
| Mixed (both types) | Tacking for capital/§1231 portion; fresh start for remainder |
| Purchased interest | Starts on date of purchase |
Reporting:
- Form 1065 = information return only; partnership pays NO entity-level tax
- Schedule K-1 provided to each partner with their share of all items
- Partners report K-1 items on their own individual returns
Partnership — Eng Basis Example (Kahoot)
Facts: Eng contributes cash ($50,000) + equipment (FMV $35,000, adj. basis $25,000) to a partnership for a 50% interest. No liabilities.
Cash contribution at basis$50,000
Equipment at ADJUSTED BASIS (not FMV)$25,000
Share of partnership debt$0
Eng's Outside Basis= $75,000
Outside basis uses ADJUSTED BASIS of contributed property, not FMV. This preserves the $10,000 built-in gain ($35,000 FMV − $25,000 basis). When the partnership sells the equipment, that $10,000 gain will be allocated to Eng under §704(c).
Partnership's inside basis in equipment = $25,000 (carryover). Partnership recognizes gain if sold above $25,000.
S Corp Election — Timing Rules
Effective CURRENT year IF filed:
Calendar year corps:On or before March 15
Fiscal year corps:By 15th day of 3rd month of tax year
Effective NEXT year IF filed:
After March 15, OR during prior year for next year
EXAM TRAP: Filed March 20 (after March 15) → effective January 1 of NEXT year. Filed February 20 → effective January 1 of CURRENT year.
Form 2553 must be signed by ALL shareholders who owned stock during the election year — not just current shareholders. Late elections may be granted reasonable cause relief.
S Corp Termination — Rules
| Type | Trigger | Effective Date | Re-election Wait |
|---|
| Voluntary revocation | >50% shareholders consent | March 15 or earlier → Jan 1 current yr; After March 15 → Jan 1 next yr | 5 years |
| Involuntary — eligibility failure | Violates any S corp requirement | Date of failure | 5 years |
| Involuntary — passive income | Passive income >25% of gross receipts for 3 consecutive years AND has accumulated C corp E&P | Jan 1 of year AFTER the 3rd year | 5 years |
If corp was NEVER a C corp (no accumulated C corp E&P) → passive income test CANNOT terminate the election, regardless of passive income levels.
IRS can consent to earlier re-election if termination was inadvertent AND corp takes remedial steps within a reasonable time.
S Corp Operations — Income Allocation
S Corp income MUST be allocated PRO RATA — strictly by share ownership each day.
- No special allocations (unlike partnerships)
- If shareholder sells stock mid-year → income allocated by days of ownership
- All separately stated items retain their character (like partnerships)
- No guaranteed payments (unlike partnerships)
- S corp income flowing to shareholders is NOT self-employment income
Reasonable Compensation Requirement:
- Shareholder-employees WHO WORK for the S corp must receive reasonable salary subject to FICA
- IRS actively targets zero-salary S corp arrangements
- Can reclassify K-1 distributions as wages → triggers employment taxes + penalties
Planning opportunity: Pay reasonable salary (FICA on wages) and take rest as K-1 distribution (no SE tax).
S Corp Shareholder Basis
Stock Basis (most common):
+ Separately stated income items
+ Ordinary business income
− Distributions (cash or FMV of property)
− Separately stated losses/deductions
− Ordinary business losses (limited to remaining basis)
KEY DIFFERENCE from partnerships: S corp shareholders CANNOT include S corp debt in stock basis. Partners CAN include their share of partnership debt in outside basis. S corp shareholders get basis ONLY from debt they personally lend directly to the S corp (creates "debt basis").
Losses suspended when basis reaches zero are restored (can deduct) when subsequent income increases basis in a later year.
S Corp vs. Partnership — Key Differences
| Feature | S Corporation | Partnership |
|---|
| Income allocation | Pro rata (rigid) | Special allocations allowed |
| Entity debt in basis | NO (S corp debt) | YES (recourse + nonrecourse) |
| Guaranteed payments | Not allowed | Yes — always ordinary + SE income |
| SE tax on income | NO (only on wages) | Yes (general partners) |
| Owner limit | 100 shareholders max | Unlimited partners |
| Owner types | Individuals/estates/certain trusts only | Any entity (corps, partnerships, etc.) |
| Stock classes | ONE class only | Flexible interest structures |
| C corp NOLs | Cannot use in S corp years | N/A |
C Corp → S Corp Conversion Issues
- C corp NOL carryforwards: Cannot be used in S corp years — suspended; only usable if corp converts back to C status
- Built-in gains tax (BIG): If S corp sells appreciated property during the 5-year recognition period (within 5 years of S election), built-in gains are taxed at the 21% corporate rate at the S corp entity level
- Passive income tax: If S corp has accumulated C corp E&P and passive income > 25% of gross receipts → 21% tax on excess net passive income
- LIFO recapture: Must include LIFO inventory reserve in last C corp year income
The BIG tax effectively extends double taxation for 5 years after S election for appreciated assets held at conversion. Plan asset dispositions accordingly.
Residence vs. Source Framework
| System | Tax Base | Who Uses It |
|---|
| Residence-based (Worldwide) | ALL income, wherever earned globally | US citizens, green card holders, substantial presence test aliens, US corporations |
| Source-based (Territorial) | Only income FROM that country's sources | Nonresident aliens, foreign corporations (for US income only) |
Mnemonic: "Residence → Worldwide" | "Source → Territory only"
US uses RESIDENCE framework for US persons, SOURCE framework for non-US persons.
Nexus: The criteria used to assert the right to tax a person or transaction. Without nexus, no jurisdiction to tax. Defined by residency, source, or physical presence (permanent establishment).
US Residency Tests
Who is a US Person for Tax?
| Status | Basis for US Residency |
|---|
| US citizen | Citizenship (worldwide income always) |
| Green card holder | Possesses immigrant visa at ANY time during the calendar year |
| Substantial Presence Test (SPT) | ≥31 days in current year AND weighted 3-year total ≥183 days |
| Nonresident alien | None of the above → taxed on US-source income only |
SPT 3-Year Formula:
Current year days × 1
Prior year days × 1/3
Two years ago days × 1/6 → Total must ≥ 183
Income Sourcing Rules
| Income Type | Source Rule | Key Word |
|---|
| Interest | Residence of the BORROWER (payer) | Borrower |
| Dividends | Residence of the CORPORATION paying | Paying corp |
| Services / Compensation | Where SERVICES ARE PERFORMED | Where performed |
| Rents & Royalties | Where PROPERTY IS LOCATED or used | Property location |
| Gain on real property | Where PROPERTY IS LOCATED | Property location |
| Gain on personal property (non-inventory) | SELLER'S residence | Seller's home |
| Gain on manufactured inventory | Where MANUFACTURING ASSETS are located | Factory location |
For compensation: Maria (US citizen) works only in Germany → German-source income, but still taxable to US (with FTC relief).
Foreign Tax Credit (FTC)
Purpose: Prevent double taxation on foreign income (foreign country AND US both want to tax it).
FTC Limitation Formula:
(Foreign source taxable income ÷ Total taxable income)
× Pre-credit US tax = FTC Limitation
Example: Total taxable income $500,000; Foreign income $100,000; Pre-credit US tax $105,000
($100,000 / $500,000) × $105,000= $21,000
Foreign taxes paid = $35,000 → limited to$21,000
Excess $14,000 → carry back 1 yr, forward 10 yrs
FTC cannot reduce US tax on DOMESTIC income. It only offsets US tax attributable to the foreign income.
FTC Baskets & Tax Treaties
4 Separate FTC Baskets (calculated independently):
- GILTI — Global Intangible Low-Taxed Income (foreign intangible income)
- Foreign Branch Income — income from foreign branch operations
- Passive Category Income — dividends, rents, royalties, interest (passive)
- General Category Income — active business income not in other baskets
Separation prevents high-tax basket income from cross-crediting against low-tax basket limitation.
Tax Treaties — 3 Main Functions:
- Define nexus / permanent establishment (when can a country tax?)
- Reduce or eliminate withholding taxes on cross-border payments (dividends, interest, royalties)
- Resolve dual-residency conflicts through tie-breaker rules
Treaties can only REDUCE or ELIMINATE tax — they can NEVER increase tax above statutory rates.
Outbound vs. Inbound Transactions
Outbound Transactions
- US person earning income outside the US
- US taxes worldwide income → potential double tax
- Mitigation: FTC, Foreign Earned Income Exclusion (FEIE)
- Example: US corp with foreign subsidiary
- Rules: Subpart F, GILTI, FDII
Inbound Transactions
- Foreign entity earning income inside the US
- Taxed only on US-source income
- Withholding tax (30% statutory, often reduced by treaty)
- Example: Foreign corp earns US interest income
- ECI vs. FDAP rules distinguish income types
"Outbound" = US going out. "Inbound" = foreign coming in.
§351 Complete 5-Step Reference Card
Memorize this framework — multiple exam questions!
Step 1: Realized Gain
= FMV(stock) + FMV(boot) + Liability relief − Adjusted basis
Step 2: Recognized Gain
= LESSER of Realized gain OR FMV of boot (LOSSES = NEVER recognized)
Step 3: Unrecognized Gain = Step 1 − Step 2
Step 4: Character = follows type of property contributed
Step 5A: SH Stock Basis (Traditional)
Old basis + Recognized gain − Boot received − Liability relief
Shortcut: FMV of stock − Unrecognized gain
Step 5B: Corp Asset Basis = SH old basis + SH recognized gain
Key Numbers & Thresholds
| Rule | Number |
|---|
| §351 Control test | 80% voting + 80% all other classes |
| §351 Services + property threshold | Property ≥ 10% of services FMV |
| C corp flat tax rate | 21% |
| DRD — <20% ownership | 50% |
| DRD — 20–79% ownership | 65% |
| DRD — ≥80% ownership | 100% |
| Charitable contribution limit (corps) | 10% of pre-contribution TI |
| S corp max shareholders | 100 |
| S corp election deadline | March 15 (calendar year) |
| §1244 ordinary loss limit (single) | $50,000/yr |
| §1244 ordinary loss limit (MFJ) | $100,000/yr |
| NOL carryforward limit | 80% of taxable income |
| NCL carryback / carryforward | 3 back / 5 forward |
| S corp re-election waiting period | 5 years |
| FTC excess credit carryback/forward | 1 back / 10 forward |
| NIIT threshold (MFJ) | $250,000 |
Exam Traps — Common Wrong Answers
| Statement | TRUE or FALSE? |
|---|
| E&P = Retained earnings | FALSE — different adjustments |
| Corps have a standard deduction | FALSE — none |
| Corps calculate AGI like individuals | FALSE — no AGI concept |
| §351 control = 80% voting power only | FALSE — also 80% all other classes |
| C corps no longer double taxed (TCJA) | FALSE — still double taxed |
| C & S corps both pay entity-level tax | FALSE — S corps are flow-through |
| SMLLC = taxed as partnership | FALSE — disregarded entity |
| §351 losses recognized if boot received | FALSE — losses never recognized |
| S corp shareholders include entity debt in basis | FALSE — only direct loans to S corp |
| Partnership character determined at partner level | FALSE — partnership level |
| Profits interests trigger ordinary income | FALSE — capital interests do; profits interests do not |
| Liquidation is always taxable to shareholders | FALSE — §332 parent-subsidiary is tax-free |
DRD — Taxable Income Limitation Example
The DRD is limited to 50% (or 65%) of taxable income computed WITHOUT the DRD — UNLESS the DRD would create or increase an NOL.
Example: Corp receives $100,000 dividend (owns 15%). Taxable income before DRD = $40,000.
Full DRD = $100,000 × 50%= $50,000
TI limitation = $40,000 × 50%= $20,000
Apply limitation → DRD = $20,000
BUT: Would full $50,000 DRD create an NOL?
$40,000 TI − $50,000 DRD= ($10,000) NOL
YES → limitation does NOT apply → use full $50,000 DRD!
Always test: Does the full DRD create/increase an NOL? If yes, use the full DRD (no limitation).
S Corp Election Scenarios — Quick Reference
| Scenario | Result |
|---|
| Form 2553 filed Feb 20 (calendar year corp) | Effective Jan 1 current year ✓ |
| Form 2553 filed March 15 (calendar year corp) | Effective Jan 1 current year ✓ |
| Form 2553 filed March 20 (calendar year corp) | Effective Jan 1 NEXT year ✗ |
| Corp sells stock to a partnership | S election terminated on date of sale |
| Corp sells stock to another eligible individual | S election continues (no termination) |
| S corp with NO accumulated C corp E&P; passive income >25% | No termination — passive income test requires C corp E&P |
| S corp passive income >25% for 3 yrs AND has C corp E&P | Termination effective Jan 1 of year 4 |
| Voluntary revocation filed June 1 | Effective Jan 1 next year (filed after March 15) |
Flow-Through Entity Comparison — Loss Deductibility
| Entity | Can Owners Deduct Losses? | Limitations |
|---|
| C corporation | NO — losses stay at corp as NOL | NOL used at entity level only (80% limit); no benefit to shareholders |
| S corporation | YES — flows through to shareholders | (1) Basis limit, (2) At-risk rules, (3) Passive activity rules |
| Partnership | YES — flows through to partners | (1) Outside basis limit, (2) At-risk rules, (3) Passive activity rules |
| Sole proprietorship | YES — on Schedule C | (1) At-risk rules, (2) Passive activity rules (if not active) |
Flow-through entities are preferred for start-ups expecting early losses — owners can immediately use losses against other income. C corp losses are "trapped."
Partnership vs. §351 — Formation Comparison
| Feature | §721 Partnership | §351 Corporation |
|---|
| Control requirement | NONE | ≥80% (voting + all other classes) |
| Services = property? | No → ordinary income | No → ordinary income |
| Gain recognized at formation? | No (unless §752(b) excess) | Only if boot received |
| Loss recognized? | Never | Never |
| Basis of interest/stock | Carryover basis | Carryover basis ± adjustments |
| Basis of contributed asset | Carryover to entity | Carryover + SH recognized gain |
| Liability assumption effect | Reduces outside basis (§752 deemed dist.) | Generally not boot (§357 general rule) |
Passive Activity & At-Risk Rules — Overview
Passive Activity Loss (PAL) Rules:
- Passive losses can ONLY offset passive income (not active income, not portfolio income)
- Suspended losses carried forward until passive income available OR passive activity sold
- Material participation = activity is NOT passive (7 tests; most common: >500 hrs/yr)
- Rental activities are ALWAYS passive (with exception for real estate professionals)
- S corp / partnership income IS passive if shareholder/partner does not materially participate
At-Risk Rules (§465):
- Can deduct losses only to the extent "at risk" in the activity
- At-risk amount includes: cash contributed, FMV of property contributed, recourse debt, qualified nonrecourse financing
- Nonrecourse debt (generally) does NOT increase at-risk amount (exception: qualified nonrecourse)
Realization vs. Recognition
These are different — know both:
REALIZATION
- The result of an exchange of property rights in a transaction
- Requires an arm's-length exchange, disposition, or identifiable event
- Gain/loss is "realized" = computed, but not necessarily taxable yet
- Formula: Amount Realized − Adjusted Basis
- Occurs before recognition
RECOGNITION
- The reporting of realized gain/loss on a tax return
- Gain/loss is "recognized" = included in taxable income currently
- Some transactions defer recognition: §351, §721, like-kind exchanges, installment sales
- Recognition can be full, partial (boot), or deferred
Amount Realized = Cash + FMV of property received + Debt assumed by buyer + Liability relief
Adjusted basis of property transferred is NOT included in amount realized.
Corporate Distribution — Full Example
Facts: Corp distributes $50,000 when Current E&P = $0; Accumulated E&P = $30,000. Shareholder has $15,000 stock basis, receives $10,000 pro rata.
Dividend portion (to extent of C E&P $0 + A E&P $30,000)
Distribution is $10,000 ≤ $30,000 accumulated E&P
Full $10,000 = DIVIDEND income to shareholder
Accumulated E&P reduced to $20,000
Shareholder's stock basis unchanged at $15,000
Return of capital and capital gain only apply when distribution EXCEEDS all available E&P. With $30,000 accumulated E&P absorbing the $10,000 distribution, it's all dividend.
§351 — Boot vs. No Boot Scenarios
| What Received | Boot? | Gain Recognized? |
|---|
| Only stock of transferee corp | No | No (full deferral) |
| Stock + cash | Yes (cash) | Yes — lesser of gain or cash |
| Stock + promissory note | Yes (note) | Yes — lesser of gain or FMV of note |
| Stock + liability assumed by corp (§357 general rule) | No | No |
| Stock + liability (§357(b) — tax avoidance) | Yes (all liability) | Yes — all liability relief is boot |
| Stock only, but liabilities > basis (§357(c)) | Yes (excess) | Yes — liabilities minus basis |
| Realized LOSS + boot received | Yes | NO — losses never recognized |