Business Tax Concepts

• Businesses are taxed differently based on their legal structure
• Three main business entities are partnerships, C corporations, and S corporations

Partnerships

• Partnerships are not taxed at the entity level; income passes through to partners
• Partnerships use Form 1065, U.S. Return of Partnership Income
• Each partner reports their share of income on their tax return using Schedule K-1

C Corporations

• C Corporations are a separate legal entity and are taxed at the corporate level
• C Corporations use Form 1120, U.S. Corporation Income Tax Return
• Profits are taxed at both corporate and shareholder levels, known as double taxation, when dividends are distributed

S Corporations

• S Corporations have pass-through taxation like partnerships, but with corporate benefits
• S Corporations use Form 1120S
• S Corporations are limited to 100 shareholders, all of whom must be U.S. citizens or residents

Key Differences Among Entities

• Sole Proprietorship
  • Tax treatment is pass-through taxation
  • Forms Used: None, Schedule C with Form 1040
  • Key Features: No separate entity tax, income reported on personal return, unlimited liability
• Partnership
  • Tax treatment is pass-through taxation
  • Forms Used: Form 1065
  • Key Features: No corporate tax, individual reporting
• C Corporation
  • Tax treatment is corporate taxation
  • Forms Used: Form 1120
  • Key Features: Double taxation, unlimited shareholders
• S Corporation
  • Tax treatment is pass-through taxation
  • Forms Used: Form 1120S
  • Key Features: Limited shareholders, no corporate tax

Important Tax Concepts

• Pass-Through Taxation: Income flows to owners without being taxed at the business level
• Double Taxation: C Corporations pay tax on profits, and shareholders pay tax on dividends
• K-1 Forms: Used by partnerships and S corporations to report income to owners

Simplified Chapter 1 Notes: Business Taxation & Key Concepts

Cash Method

• Income is recorded when money is received
• Expenses are recorded when money is paid
• Commonly used by small businesses and individuals, cash method is simple and straightforward
• Income Example: Complete a project in December but get paid in January means record income in January when payment is received
• Expense Example: Buy office supplies in December but pay in January means record expense in January when payment is made

Accrual Method

• Income is recorded when it is earned, even if payment hasn't been received
• Expenses are recorded when they are incurred, even if payment hasn't been paid
• The accrual method is more accurate for tracking business performance
• Commonly used by larger businesses or those with inventory
• Income Example: Complete a project in December but get paid in January means record income in December when work is done
• Expense Example: Buy office supplies in December but agree to pay in January means record expense in December when the supplies are received

Key Differences Between Cash and Accrual Methods

• Cash Method: Focus on when money actually changes hands
• Accrual Method: Focus on when the transaction occurs, regardless of when money changes hands

Business Gross Income

• Gross Receipts Test: Determines if a business qualifies as a small business
  • Applies if the average gross receipts for the past 3 years do not exceed $30 million as of 2024
  • Includes total sales, service revenue, and investment income

Business Deductions

• Ordinary & Necessary Expenses:
  • Ordinary expenses are common in the business industry
  • Necessary expenses are helpful for business operations
• Reasonable Amounts means deductions are limited to reasonable expenses
• Common Deductible Expenses: Rent, salaries, supplies, and utilities

Limitations on Business Deductions

• Non-Deductible Expenses:
  • Illegal payments (bribes, fines, penalties)
  • Political contributions and lobbying expenses
  • Personal expenses unless directly related to business

Capital Expenditures

• Costs for long-term assets must be capitalized and depreciated or amortized over time

Mixed-Motive Expenses

• Business meals are only 50% deductible if related to business
• Travel expenses are deductible if away from home overnight
• Property use expenses must be allocated between personal and business use

Business Interest Deduction Limits

• Deductible interest is limited to business interest income + 30% of adjusted taxable income
• Businesses under the gross receipts test are exempt
• Disallowed interest can be carried forward indefinitely

Business Losses

• Loss on Property Sales: Deductible unless sold to a related party
• Casualty Losses: Deductible if assets are damaged or destroyed, based on insurance coverage

Accounting Periods & Methods

• Accounting Periods:
  • Individuals use a calendar year
  • C Corporations can choose fiscal or calendar years
  • Partnerships & S Corporations must align with owner tax years
• Accounting Methods:
  • Cash Method: Recognizes income when received and expenses when paid, simpler
  • Accrual Method: Recognizes income when earned and expenses when incurred
• Inventory Costing Methods:
  • FIFO (First-In, First-Out)
  • LIFO (Last-In, First-Out, only allowed if also used in financial statements
  • Specific Identification

Advance Payments

• Cash Method: Income taxable in the year received
• Accrual Method: Can defer recognition for one year in some cases

Bad Debt Expense

• Deductible only when debts are proven uncollectible (direct write-off method)

Limits on Related Party Transactions

• Accrual method businesses cannot deduct expenses owed to related parties until they recognize income

Change in Accounting Method

• Form 3115 must be filed

Test your knowledge of business tax concepts. Questions cover interest expense deduction limitations, tax year alignment, income recognition for accrual businesses, and inventory costing methods. Also tests knowledge of double taxation.