PassKey EA Review Part 2 Businesses PDF

EA Review Part 2: Businesses Enrolled Agent Study Guide May 1, 2024 - February 28, 2025 Testing Cycle Joel Busch, CPA, JD Christy Pinheiro, EA, ABA® Thomas A. Gorczynski, EA, USTCP ...

EA Review Part 2: Businesses Enrolled Agent Study Guide May 1, 2024 - February 28, 2025 Testing Cycle Joel Busch, CPA, JD Christy Pinheiro, EA, ABA® Thomas A. Gorczynski, EA, USTCP  PassKey EA Review 2024-2025 Edition Executive Editor: Joel Busch, CPA, JD Contributors: Joel Busch, CPA, JD Christy Pinheiro, EA, ABA® Thomas A. Gorczynski, EA, USTCP PassKey Learning Systems EA Review Part 2 Businesses; Enrolled Agent Study Guide, May 1, 2024-February 28, 2025 Testing Cycle ISBN 13: Online Edition First Printing. April 1, 2024. PassKey EA Review® and PassKey Learning Systems® are U.S. Registered Trademarks. The Hock International brand name and the Hock International logo are the property of their respective owners. Cover photography licensed with permission. Cover image photo © Mykhailo Polenok | Dreamstime.com. All Rights Reserved © 2024, PASSKEY ONLINE EDUCATIONAL SERVICES INC. Revised and updated every year, based on updated IRS EA exam specifications. United States laws and regulations are public domain and not subject to copyright. The editorial arrangement, analysis, and professional commentary are subject to this copyright notice. No portion of this book may be copied, retransmitted, reposted, duplicated, or otherwise used without the express written approval of the publisher. Questions for this study guide have been adapted from previous IRS Special Enrollment Examinations and from current IRS publications. The authors have also drafted new questions. All the names used in this book are fictitious, and any resemblance to real people, companies, or events is purely coincidental. Official company website: www.PassKeyOnline.com 2  PassKey EA Review 2024-2025 Edition This study guide is designed for exam candidates who will take their exams in the May 1, 2024, to February 28, 2025, testing cycle. Note: Prometric will NOT TEST on any legislation or court decisions passed after December 31, 2023. For exams taken between May 1, 2024, to February 28, 2025, all references on the examination are to the Internal Revenue Code, forms and publications, as amended through December 31, 2023. Also, unless otherwise stated, all questions relate to the calendar year 2023. Questions that contain the term ‘current tax year’ refer to the calendar year 2023. 3  PassKey EA Review 2024-2025 Edition Table of Contents Essential Tax Law Figures for Businesses..................................................................... 13 Unit 1: Business Entities and Requirements................................................................ 19 Unit 2: Accounting Periods and Methods....................................................................... 46 Unit 3: Business Income........................................................................................................ 76 Unit 4: Business Expenses.................................................................................................... 97 Unit 5: Employee Compensation and Fringe Benefits........................................... 127 Unit 6: Other Business Deductions and Credits....................................................... 155 Unit 7: Basis of Business Assets...................................................................................... 180 Unit 8: Depreciation and Amortization....................................................................... 197 Unit 9: Disposition of Business Assets......................................................................... 219 Unit 10: Partnerships in General.................................................................................... 246 Unit 11: Partnership Distributions and Liquidations............................................ 273 Unit 12: C Corporations in General................................................................................ 286 Unit 13: Corporate Transactions.................................................................................... 306 Unit 14: Corporate Distributions and Liquidations................................................ 325 Unit 15: S Corporations...................................................................................................... 343 Unit 16: Farming Business................................................................................................ 370 Unit 17: Tax-Exempt Organizations.............................................................................. 391 Unit 18: Retirement Plans for Businesses.................................................................. 409 Unit 19: Trusts and Estates............................................................................................... 439 4  PassKey EA Review 2024-2025 Edition Recent Praise for the PassKey EA Review Series (Real customers, real names, public testimonials) Perfect review book! A. Bergman The [PassKey] EA Review is great! Goes into detail and explains why. When you do the practice test, it actually tells you details of the answer for learning and retaining! Definitely recommend! Fantastic textbooks and video resources. Vino Joseph Philip Comprehensive and accurate video lessons are available online, and testing is also available for each course. I passed all three exams on the first attempt after using Passkey’s resources. Helped me to pass faster Mohamed Helemish I highly recommend Passkey if you are looking for something simple, and easy to understand, and if you want a good reference for your future career in taxes. I passed the exam with confidence and I used it with the three parts. Passed on the first attempt! William Collins I passed the first time with the PassKey Part 2 [textbook] for the EA SEE 2 exam. I also used the Part 1 textbook and passed that EA exam on the first try as well. Great resources! I Highly recommend these materials Tosha H. Knelangeon Using only the [PassKey] study guide and the workbook, I passed all three EA exams on my first try. I highly recommend these materials. As long as you put in the time to read and study all the information provided, you should be well-prepared. I passed on the first try. Jake Bavaro I recently passed the first part of the EA exam using just the textbook and a separate practice test workbook. The textbook is very easy to read and understand. Although I have a background in accounting and tax, someone with little or no knowledge of either should be able to grasp all of the various topics covered in the book. I really do believe that it is a superior preparation resource. I passed all three parts the first time taking them. Sheryl Reinecke I passed all three parts the first time. I read each chapter and the review quiz at the end of each chapter. Before taking the real exam, I did the practice exams in the additional workbook. I feel the material adequately prepared me for success in passing the exam. 5  PassKey EA Review 2024-2025 Edition You can pass. Vishnu Kali Osirion I really rushed studying for this section. These authors make tax law relevant to your day-to-day experiences and understandable. You can pass the exam with just this as a resource. I do recommend purchasing the workbook as well, just for question exposure. The questions in the book and in the workbook are pretty indicative of what’s on the exam. This is a must-buy. Cheers. Absolute Best Purchase Sharlene D. This book was definitely worth the purchase. The layout was great, especially the examples! Reading the book from front to back allowed me to pass [Part 2]. I also recommend purchasing the workbook or subscribing to the material on their website for this section. Excellent explanations! Janet Briggs The best thing about these books is that each answer has a comprehensive explanation about why the answer is correct. I passed all three EA exams on the first attempt. PassKey was the only study aid that I used Stephen J Woodard, CFP, CLU, ChFC The [PassKey] guides were an invaluable resource. They were concise and covered the subject matter succinctly with spot-on end-of-chapter questions that were very similar to what I encountered on the exams. Amazing! Sopio Svanishvilion PassKey helped me pass all three parts of the Enrolled Agent exam. They are a “must-have” if you want to pass your EA exams. I passed all three with Passkey. Swathi B.R. I went through the online membership, read the whole book, solved all the questions, and passed the EA exam on my first attempt. For all three [parts], I referred to Passkey EA Review. Wonderful books. Passed all 3 Parts! Kowani Collins Thank you so much for providing this resource! I have passed all 3 parts of the SEE exam. PassKey allowed me to study on my own time and take the exam with confidence. Thank you for providing such thorough and easy-to-follow resources! 6  PassKey EA Review 2024-2025 Edition Introduction Congratulations on taking the first step toward becoming an enrolled agent, a widely respected professional tax designation. The Internal Revenue Service licenses enrolled agents, known as EAs, after candidates pass a competency exam testing their knowledge of federal tax law. As an enrolled agent, you will have the same representation rights as a CPA, with the ability to represent taxpayers in IRS audits and appeals—an EA’s rights are unlimited before all levels and offices of the IRS. The PassKey study guide series is designed to help you study for the EA exam, which is formally called the IRS Special Enrollment Examination or “SEE.” EA Exam Basics The EA exam consists of three parts, which candidates may schedule separately and take in any order they wish. The computerized exam covers all aspects of federal tax law, with Part 1 testing the taxation of individuals; Part 2 testing the taxation of businesses, and Part 3 testing representation, practice, and procedures. Each part of the EA exam features 100 multiple-choice questions, with no written answers required. The exam will include some experimental questions that are not scored. You will not know which of the questions count toward your score and which do not. Computerized EA Exam Format Part 1: Individual Taxation–100 questions Part 2: Business Taxation–100 questions Part 3: Representation, Practice, and Procedures–100 questions You will have 3.5 hours to complete each part of the exam. The actual seat time is four hours, which allows time for a pre-exam tutorial and a post-exam survey. An on-screen timer counts down the amount of time you have to finish. The testing company Prometric exclusively administers the EA exam at thousands of testing centers across the United States and in certain other countries. You can find valuable information and register online at https://www.prometric.com/IRS. Prometric Testing Center Procedures The testing center is designed to be a secure environment. The following are procedures you will need to follow on test day: 1. Check in about thirty minutes before your appointment time and bring a current, government- issued ID with a photo and signature. If you do not have a valid ID, you will be turned away and will have to pay for a new exam appointment. Refunds will not be issued by Prometric if you forget to bring a proper ID with you. 2. The EA exam is a closed-book test, so you cannot bring any notes or reference materials into the testing room. The center supplies sound-blocking headphones if you want to use them. 3. No food, water, or other beverages are allowed in the testing room. 4. You will be given scratch paper and a pencil to use, which will be collected after the exam. 7  PassKey EA Review 2024-2025 Edition 5. You can use an on-screen calculator during the exam, or Prometric will provide you with a handheld calculator. You cannot bring your own calculator into the examination room. 6. Before entering the testing room, you may be scanned with a metal detector wand. 7. You must sign in and out every time you leave the testing room. 8. You cannot talk or communicate with other test-takers in the exam room. Prometric continuously monitors the testing room via video, physical walk-throughs, and an observation window. Important Note: Violating any of these procedures may result in the disqualification of your exam. In cases of cheating, the IRS says candidates are subject to consequences that include civil and criminal penalties. Break Policy: The Special Enrollment Exam (SEE) now includes one scheduled 15-minute break. You may decline the scheduled break and continue testing. If you choose to take the scheduled break, you will leave the testing room, adhering to all security protocols. You can take additional unscheduled breaks; however, the exam clock will continue to count down during any unscheduled break. Exam-takers who require special accommodations under the Americans with Disabilities Act (ADA) must contact Prometric directly to obtain an accommodation request. The test is administered in English; a language barrier is not considered a disability. Exam Content Each year, using questions based on the prior calendar year’s tax law, the IRS introduces multiple new versions of each part of the EA exam. If you fail a particular part of the exam and need to retake it, do not expect to see identical questions the next time. Prometric’s website includes broad content outlines for each exam part. When you study, make sure you are familiar with the items listed, which are covered in detail in your PassKey guides. Questions from older exams are available on the IRS website for review. Be aware that tax laws change yearly, so be familiar with recent updates. Your PassKey study guides present an overview of all the major areas of federal taxation that enrolled agents typically encounter in their practices and are likely to appear on the exam. Although our guides are designed to be comprehensive, we suggest you also review IRS publications and try to learn as much as possible about tax law in general, so you are well-equipped to take the exam. In addition to this study guide, we highly recommend that all exam candidates read: Publication 17, Your Federal Income Tax (for Part 1 of the exam), and Circular 230, Regulations Governing Practice before the Internal Revenue Service (for Part 3 of the exam) You may download these publications for free from the IRS website. Note: Some exam candidates take Part 3: Representation, Practice, and Procedures first rather than taking the tests in order, since the material in Part 3 is considered less complicated. However, test- takers should know that several questions pertaining to taxation of Individuals (Part 1) and Businesses (Part 2) are often included on the Part 3 exam. 8  PassKey EA Review 2024-2025 Edition Exam Strategy Each multiple-choice question has four answer choices. There are several different question formats. During the exam, you should read each question thoroughly to understand precisely what is being asked. Be particularly careful when the problem uses language such as “not” or “except.” Format One–Direct Question Which of the following entities are required to file Form 709, United States Gift Tax Return? A. An individual B. An estate or trust C. A corporation D. All of the above Format Two–Incomplete Sentence Supplemental wages do not include payments for: A. Accumulated sick leave B. Nondeductible moving expenses C. Vacation pay D. Travel reimbursements paid at the federal government’s per diem rate Format Three–All of the Following Except Five tests must be met for you to claim an exemption for a dependent. Which of the following is not a requirement? A. Citizen or Resident Test B. Member of Household or Relationship Test C. Disability Test D. Joint Return Test If you are unsure of an answer, you may mark it for review and return to it later. Try to eliminate clearly wrong answers from the four possible choices to narrow your odds of selecting the right answer. But be sure to answer every question, even if you have to guess, because all answers left incomplete will be marked as incorrect. Each question is weighted equally. There may also be a limited number of questions that have four choices, with three incorrect statements or facts and only one with a correct statement or fact, which you would select as the right answer. With 3.5 hours allotted for each part of the exam, you have about two minutes per question. Try to answer the questions you are sure about quickly, so you can devote more time to those that include calculations or that you are unsure about. Allocate your time wisely. To familiarize yourself with the computerized testing format, you may take a tutorial on the Prometric website. The tutorial illustrates what the test screens look like. 9  PassKey EA Review 2024-2025 Edition Scoring Methods The EA exam is not graded on a curve. The IRS determines scaled scores by calculating the number of questions answered correctly from the total number of questions in the exam and converting to a scale that ranges from 40 to 130. The IRS has set the scaled passing score at 105, which corresponds to the minimum level of knowledge deemed acceptable for EAs. After you finish your exam and submit your answers, you will exit the testing room, and Prometric will send your results to your email, showing whether you passed or failed. Test results are automatically shared with the IRS, so you do not need to submit them yourself. Test scores are confidential and will be revealed only to you and the IRS. If you pass, your printed results will show a passing designation but not your actual score. The printout also will not indicate which specific questions you answered correctly or incorrectly. If you fail, you will receive diagnostic information to help you know which subject areas to concentrate on when studying to retake the exam: Level 1: Area of weakness where additional study is necessary. Level 2: Might need additional study. Level 3: Clearly demonstrated an understanding of the subject area. These diagnostic indicators correspond to various sections of each part of the exam. If necessary, you may take each part of the exam up to four times during the current testing window. You will need to re-register with Prometric and pay fees each new time you take an exam part. Due to the global pandemic, the IRS extended the two-year carryover period to three years for passing all three parts of the exam. Example: Randall, an EA exam candidate, successfully passed Part 1 on November 15, 2021. Subsequently, he passed Part 2 on February 15, 2022. Randall has until November 15, 2024, to pass the remaining part. Otherwise, he loses credit for Part 1. Randall has until February 15, 2025, to pass all other parts of the examination or he will lose credit for Part 2. Applying for Enrollment Once you have passed all three parts of the EA exam, you can apply to become an enrolled agent. The process includes an IRS review of your tax compliance history. Failure to timely file or pay personal income taxes can be grounds for denial of enrollment. The IRS Return Preparer Office will review the circumstances of each case and make determinations on an individual basis. You may not practice as an EA until the IRS approves your application and issues you an enrollment card, a process that takes up to 60 days or more. Successfully passing the EA exam can launch you into a fulfilling and lucrative new career. The exam requires intense preparation and diligence, but with the help of PassKey’s comprehensive EA Review, you will have the tools you need to learn how to become an enrolled agent. We wish you much success! 10  PassKey EA Review 2024-2025 Edition Ten Steps for the EA Exam STEP 1: Learn Learn more about the enrolled agent designation, and explore the career opportunities that await you after passing your EA exam. In addition to preparing income tax returns for clients, EAs can represent individuals and businesses before the IRS, just as attorneys and CPAs do. A college degree or professional tax background is not required to take the EA exam. Many people who use the PassKey study guides have had no prior experience preparing tax returns, but go on to rewarding new professional careers. STEP 2: Gather Information Gather more information before you launch into your studies. You will find valuable information about the exam itself on the Prometric testing website at www.prometric.com/IRS. Be sure to download the official Candidate Information Bulletin, which takes you step-by-step through the registration and testing process. STEP 3: Obtain a PTIN PTIN stands for “Preparer Tax Identification Number.” Before you can register for your EA exam, you must obtain a PTIN from the IRS. The PTIN sign-up system can be found at www.irs.gov/ptin. You will need to create an account and provide personal information. Foreign-based candidates without a Social Security number are also required to have a PTIN to register to take the exam; they will need to submit additional paperwork with their Form W-12 (PTIN Application and Renewal). STEP 4: Register with Prometric Once you have your PTIN, you may register and schedule your exam on the Prometric website by creating an account to set up your user ID and password. Alternatively, you can schedule an appointment to take the exam by calling 800-306-3926 (toll-free) or 443-751-4193 (toll), Monday through Friday, between 8 a.m. and 9 p.m. (ET); or by submitting IRS Form 2587. STEP 5: Schedule Your Test After creating an account, you can complete the registration process by clicking on “Scheduling.” Your exam appointment must be scheduled within one year from the registration date. You can choose a test site, time, and date that is convenient for you. Prometric has test centers in most major metropolitan areas of the United States, as well as in many other countries. You may schedule your exam through the website or call Prometric directly Monday through Friday (some centers have Saturday testing). The testing fee is nonrefundable. Once you have scheduled, you will receive a confirmation number. Keep it for your records because you will need it to reschedule (which may incur a charge), cancel, or change your appointment. STEP 6: Adopt a Study Plan Focus on one exam part at a time and adopt a study plan that covers each unit of your PassKey guides. The period of time you’ll need to prepare for each exam is truly unique to you, based on how 11  PassKey EA Review 2024-2025 Edition much prior tax preparation experience you have and your current level of tax knowledge, how well you understand and retain the information you read, and how much time you have to study for each test. For those without prior tax experience, a good rule of thumb is to study at least 60 hours for each of the three exam sections. Part 2: Businesses may require additional study preparation, as evidenced by the lower pass rates. One thing is true for all candidates: for each of the tests, start studying well in advance of your scheduled exam date. STEP 7: Get Plenty of Rest and Good Nutrition Get plenty of rest, exercise, and good nutrition before the EA exam. You will want to be at your best on exam day. STEP 8: Test Day Be sure to arrive early at the test site. Prometric advises arriving at least 30 minutes before your scheduled exam time. If you miss your appointment and cannot take the test, you will forfeit your fee and must pay for a new appointment. Remember to bring a government-issued ID with your name, photo, and signature. Your first and last name must exactly match the first and last name you used to register for the exam. STEP 9: During the Exam This is when your hard work finally pays off. Focus and don’t worry if you don’t know the answer to every question, but make sure you use your time well. Give your best answer to every question. All questions left blank will be marked as wrong. STEP 10: Congratulations. You Passed! After celebrating your success, you need to apply for your EA designation by filling out Form 23, Application for Enrollment to Practice Before the Internal Revenue Service. Once your application is approved, you will be issued an enrollment card and you will officially be a brand-new enrolled agent! 12  PassKey EA Review 2024-2025 Edition Essential Tax Law Figures for Businesses Here is a quick summary of some important tax figures for the enrolled agent exam cycle that runs from May 1, 2024, to February 28, 2025. Study Note: The IRS has stated in the most recent version of the official Prometric SEE Candidate Bulletin that candidates should not take into account any legislation or court decisions made after December 31, 2023. Legislation Affecting the 2023 Tax Year: The SECURE Act 2.0 was signed into law on December 29, 2022, as part of the Consolidated Appropriations Act of 2023. The Act included dozens of provisions affecting retirement plans. Most of the provisions in the SECURE Act 2.0 went into effect in 2023. The Corporate Transparency Act (the “CTA”) was enacted by Congress as part of the National Defense Authorization Act. The CTA establishes a beneficial ownership reporting requirement for corporations, LLCs, and other similar entities formed or registered to do business in the United States. Starting on January 1, 2024, the CTA will mandate certain types of entities to submit a beneficial ownership information (BOI) report to the Financial Crimes Enforcement Network (FinCEN). Note that according to the testing specifications for the EA exam for this testing window, BOI reports are not included as a testable item on the exam. 2023 General Filing Deadlines If a due date falls on a weekend or legal holiday, the deadline is pushed to the next business day. Individual filing deadline: April 15, 2024. This is the last day to file an individual extension (Form 4868). Extended due date: October 15, 2024. Estates and Trusts Income Tax Return Deadline (Form 1041): April 15, 2024 (extension period of 5½ months; due September 30 for a calendar-year entity). Estate Tax Return Deadline (Form 706): Due within nine months after the date of the decedent’s death (a 6-month extension is available). Partnership Deadline (Form 1065): March 15, 2024 (extended due date: September 16, 2024), or the 15th day of the 3rd month after the end of the partnership’s tax year, for fiscal- year filers. S Corporation Deadline (Form 1120-S): March 15, 2024 (extended due date: September 16, 2024) or by the 15th day of the 3rd month after the end of the tax year for fiscal year-filers. C Corporation Deadline (Form 1120): April 15, 2024 (extended due date: October 15, 2024), or the 15th day of the fourth month after the end of the corporation’s tax year, in the case of most fiscal-year filers. Exempt Entity Deadline (Form 990): May 15 for a calendar-year exempt entity (extended due date: November 15). Employee benefit plan (Form 5500 series): Due the last day of the 7th calendar month after the end of the plan’s tax year; July 31 for a calendar-year plan (an extension is available to October 15 for a calendar-year plan). 13  PassKey EA Review 2024-2025 Edition FBAR: The official due date for the FBAR (FinCen 114) coincides with the filing of the federal tax return (normally April 15). However, an automatic extension is allowed until October 15. 2023 Maximum Compensation Subject to FICA OASDI maximum wage base: $160,200 Employee and employer portion: 7.65% (6.2% Social Security + 1.45% Medicare) Self-employed 15.30% (12.4% Social Security + 2.9% Medicare) Maximum FICA/SE Tax Employee: $9,932.40 Self-employed: $19,864.80 (12.4% of $160,200) Medicare tax: no limit Additional Medicare Tax: 0.9% on earned income exceeding the following thresholds: Married filing jointly: $250,000 Married filing separately: $125,000 Single, HOH, and QSS: $200,000 Estimated Tax Due Dates: Individuals: Quarterly estimated taxes are generally due by April 15, June 15, September 15, and January 15 of the following year. Farmers and Fishermen: January 15 (if not filing a return by March 1) or March 1 (if filing a tax return and paying all taxes due by March 1). Corporations: April 15, June 15, September 15, and December 15 (for calendar-year corporations). 2023 FUTA Wage Base: The FUTA tax rate is 6% on the first $7,000 paid to each employee. Only the employer pays FUTA tax. The tax is not withheld from the employee’s wages. 2023 Net Investment Income Tax (NIIT): The tax is 3.8% of the lesser of: Net investment income, or The amount of modified adjusted gross income (MAGI) over $14,450 for Estates and trusts. 2023 Excess business loss limitation: $578,000 for joint filers and $289,000 for all other filing statuses. Excess losses over these amounts must be carried forward. Excess business losses that are disallowed are treated as a net operating loss carryover to the following taxable year. Form 1099 Deadlines: The deadline for distributing 1099s and W-2s to the payees is January 31. Gross receipts threshold for the cash method has increased to over $29 million in 2023. 14  PassKey EA Review 2024-2025 Edition 2023 Estate and Trust Exemption Amounts Estate Exemption Amount: $600 Simple trust: $300 Complex trust: $100 Qualified disability trust: $4,700 2023 Estate and Gift Tax Exclusion Amounts Estate and gift tax (highest rate): 40% Combined Estate tax and lifetime gift/GST exemption: $12,920,000 Gift tax annual exclusion: $17,000 Annual exclusion for gifts to noncitizen spouse: $175,000 2023 Contribution Limits – Retirement Plans Roth and traditional IRAs: $6,500 ($7,500 for taxpayers age 50 or older) Roth IRA contribution limit phaseout (MAGI): $138,000 to $153,000 – Single and HOH $218,000 to $228,000 – Married filing jointly $0 to $10,000 – Married filing separately (lived with spouse) SIMPLE IRA/SIMPLE 401(k): $15,500 ($19,000 age 50 and older) Traditional 401(k)/403(b) plan Employee Elective Deferral Limits: $22,500 ($30,000 age 50 or older). SEP-IRA contribution limits (employee + employer): Up to 25% of compensation, up to a maximum contribution of $66,000 SEP-IRA contributions can be made up to the due date of the return, including extensions. Qualified plan contribution limits: The limit on annual benefits for a participant in a defined benefit plan is $330,000 for 2023. 2023 Section 179 Expense: Maximum deduction amount: $1,160,000 Beginning placed-in-service phaseout limitation: $2,890,000 Spending cap: $3,780,000 (complete phaseout of the 179 election) Heavy SUV Limit: $28,900 2023 Bonus Depreciation: The former 100% bonus depreciation phases down to 80% in 2023. 2023 QBI deduction Limits: The Section 199A limitation phase-in ranges increased in 2023 and are as follows: Married Filing Joint: $364,200-$464,200 All other filing statuses: $182,100-$232,100 15  PassKey EA Review 2024-2025 Edition 2023 Standard Mileage Rates: Business use: 65.5 cents a mile Medical and moving: 22 cents a mile for medical or Armed Forces moving purposes Charitable: 14 cents a mile in service of charitable organizations 2023 Qualified Transportation Benefits: Commuter benefits/transit passes: $300 per month. Parking: $300 per month. 2023 HSA and HDHP Limits: To qualify to contribute to a health savings account, the taxpayer must have a high-deductible health insurance policy. The plan must also have an annual limit on out-of- pocket expenses (not including premiums). 2023 Plan Limits for HSAs and High-Deductible Health Plans HSA contribution limit (employer + employee) Self-only: $3,850, Family: $7,750 HSA contribution limit (age 55 or older) Self-only: $4,850, Family: $8,750 HDHP minimum deductibles Self-only: $1,500, Family: $3,000 HDHP maximum out-of-pocket amounts (this Self-only: $7,500, Family: $15,000 amount includes deductibles, co-payments, and other amounts, but not insurance premiums) Note: Catch-up contributions of $1,000 for qualified individuals can be made any time during the year in which the HSA participant turns 55. 2023 QSEHRA Limits (Maximum payments and reimbursements through the QSEHRA): $5,850 for the employee only; or $11,800 for an employee plus family members of the employee 2023 FSA Limits: Health Care FSA (HCFSA): $3,050 with a maximum carryover of $610 in 2023 Dependent Care FSA (DCFSA): $5,000 for unmarried filers and couples filing jointly, and $2,500 for married couples filing separately. 2023 “Nanny Tax” on Household Employees: The nanny tax threshold is $2,600 in 2023. A household employer is normally obligated to withhold and pay federal FICA (Social Security and Medicare) taxes for any household employee they paid $2,600 or more during the year. A household employer is required to pay FUTA taxes if they paid a household employee $1,000 or more in a calendar quarter in the current or prior year. These thresholds are on a per-employee basis. 16  PassKey EA Review 2024-2025 Edition Tax Law Updates for Businesses 2023 Meal Deduction Rules: Businesses, including self-employed taxpayers, may claim 50% of food or beverage expenses through December 31, 2023. The 50% meal expense deduction also applies to the meal portion of a per diem rate or allowance. Business meals purchased at any other setting or venue are still generally subject to the 50% limitation. 2023 Charitable Contribution limits: C Corporations can deduct charitable contributions up to 10% of taxable income. An increased, 15% limit is permitted for charitable contributions of food inventory and science equipment to institutions of higher learning or to scientific research organizations. Increase in penalty for failure to file: For tax years beginning in 2023, the penalty for failure to file a tax return that is more than 60 days shall not be less than (1) the lesser of $485 or (2) 100% of the tax due on the return. This penalty applies to Form 1120 and Form 1040 returns. Partnership and S corporation late filing penalties: Standard failure-to-file penalties are $235 per month, per partner or shareholder in a partnership or an S corporation for business returns filed in 2024 (for 2023 tax year returns). Form 1099-K Reporting Requirement Delayed Again in 2023: The reporting requirement for Form 1099-K, Payment Card and Third-Party Network Transactions, was originally reduced to $600 by the American Rescue Plan Act of 2021. However, on November 21, 2023, the IRS issued Notice 2023- 74, announcing an additional delay in the new 1099-K reporting threshold. The previous requirement of $20,000 in payments and/or over 200 transactions will remain in effect for tax year 2023. Personal transfers between friends and family are exempt from this requirement as clarified by the IRS. Corporate AMT: The Tax Cuts and Jobs Act permanently eliminated the graduated rates for C Corporations. All C corporations are now taxed at a flat rate of 21%. The TCJA also permanently repealed the prior corporate alternative minimum tax (AMT), but the Inflation Reduction Act of 2022 reintroduced a new corporate AMT, effective for tax year 2023, but with major changes. This new corporate AMT applies only to certain corporations with average annual income over $1 billion from the prior three tax years. Credit for Small Employer Pension Plan Startup Costs: Effective for 2023, SECURE Act 2.0 doubled the tax credit for new plans for small businesses with up to 50 employees to cover 100% of plan start-up costs. Employers with 51 – 100 employees may qualify for a credit of 50% of pension plan start-up costs. Qualifying small employers are also allowed an additional credit for employer contributions, up to $1,000 per employee. Digital Asset Question for Entities: Beginning in 2023, the IRS has added a question about digital assets to business entity tax forms, covering partnerships, corporations, S corporations, and estates and trusts for 2023 tax returns. The question: “At any time during 2023, did the [entity] (a) receive (as a reward, award, or payment for property or services), or (b) sell, exchange, or otherwise dispose of a digital asset (or financial interest in a digital asset)?” 17  PassKey EA Review 2024-2025 Edition 2023 E-file Mandate: New regulations have been released by The Department of the Treasury and the Internal Revenue Service on February 23, 2023, regarding the electronic filing of returns and other documents. Starting January 1, 2024, businesses will now be required to e-file if they file 10 or more information returns. Filers must aggregate almost all return types covered by the regulation to determine whether a filer meets the 10-return threshold (previously, a 250-return threshold applied separately to each type of information return). These new regulations remove the asset threshold and significantly expands the number of entities that must e-file for the 2023 tax year and moving forward. A waiver may be requested in cases of undue hardship. Failure to e-file, when required, may result in penalties imposed on taxpayers and businesses who file their information returns on paper instead. The ten-return threshold does not make electronic filing mandatory for employment tax returns, such as Forms 940 and 941. IRIS Platform for Form 1099 filings: Under the Taxpayer First Act, the IRS was tasked with creating an online portal by January 1, 2023 for taxpayers to submit Form 1099 electronically. On January 25, 2023, the Information Returns Intake System (IRIS) officially launched, providing a secure and accurate way for businesses of any size to file their 1099 forms without needing special software. This service is available for free and may be particularly beneficial for small businesses that currently file paper forms with the IRS. FBAR penalties: For the purposes of the “non-willful” civil penalty, on February 28, 2023, in a 5-4 decision, the United States Supreme Court ruled that this penalty applies per FBAR report - not for each reportable foreign account. Therefore, even if an individual has multiple reportable foreign bank accounts with a “non-willful” FBAR violation, only one civil penalty can be imposed on the taxpayer for the year. Prior to this decision, there was a split in the lower courts about whether the non-willful civil penalty could be imposed per FBAR report or for each reportable foreign account. 2023 Net Operating Losses: NOLs arising in tax year 2023 may only be carried forward. A NOL deduction cannot exceed more than 80% of taxable income. Losses generated prior to 2018 are not subject to the 80% limitation and must be accounted for separately. An NOL may be carried forward indefinitely until the loss is used up or the taxpayer dies. For pass-through entities (partnerships and S corporations), the NOL is applied at the partner and shareholder level. Farmer exception: Farming businesses have a 2-year carryback. An election may be made to waive the carryback period. If an NOL consists of both a farming loss and a non-farming loss, the losses should be treated separately. The farming loss is treated as a separate NOL and taken into account only after the non-farming NOL is applied. Exception for casualty insurance companies: Property and casualty insurance companies are allowed a 2-year carryback period for NOLs. An election may be made to waive the carryback period. These companies’ NOL carryforward is limited to 20 years and the 80% limitation does not apply. Form 1120-W Discontinued: Beginning with the 2023 tax year, Form 1120-W, Corporation Estimated Tax, is no longer used to compute the amount of estimated tax due in any quarter. Corporations must deposit all payments using the Electronic Federal Tax Payment System (EFTPS). Instructions on how to calculate estimated tax payments are available in IRS Publications 542, 18  PassKey EA Review 2024-2025 Edition Unit 1: Business Entities and Requirements More Reading: Publication 334, Tax Guide for Small Business Publication 583, Starting a Business and Keeping Records Publication 505, Tax Withholding and Estimated Tax Publication 1544, Reporting Cash Payments of Over $10,000 For Part 2 of the enrolled agent exam, you will be expected to know a broad range of information about tax provisions that affect various types of businesses. You will need to understand the different types of businesses, including sole proprietorships, partnerships, limited liability companies, corporations, and farming businesses, as well as trusts and estates, retirement plans, tax-exempt organizations, and the special tax laws that apply to each. For examinations delivered between May 1, 2024 and February 28, 2025, Part 2 of the exam is broken down into the following sections and corresponding percentages of questions: 1. Business Entities – 30 questions 2. Business Financial Information – 37 questions 3. Specialized Returns and Taxpayers – 18 questions1 We start with an overview of the different types of business entities. Each has its own drawbacks, risks, and benefits. Which entity a business should use is primarily a legal and financial decision, although there are other factors to consider, especially after the enactment of the TCJA. We briefly review each entity type in this chapter and will examine more complex entities in greater depth in later units. Sole Proprietorships A sole proprietorship is the simplest business type and also the easiest to start. An estimated 70% of businesses in the United States are sole proprietorships. A sole proprietorship is not a separate legal entity; it is an unincorporated business that is owned and controlled by one person. A sole proprietorship may be a single-person business, or it may have several employees, but there is only one owner who accepts all the risk and liability of the business. A sole proprietorship cannot be passed on to a new owner as the same business entity because, by definition, a sole proprietorship is owned and operated by a single, specific individual. If a business operated as a sole proprietorship is sold, it must be operated by the new owner as either a different sole proprietorship or as a different type of business entity through a sale of assets of the business. A taxpayer does not have to conduct full-time business activities to be considered self-employed. Operating a part-time business in addition to having a regular job or business may also be self- employment, and may also constitute a sole proprietorship. An activity qualifies as a business if its primary purpose is for profit, and if the taxpayer is involved in the activity with continuity and regularity. A hobby, which is not conducted for profit, does not qualify as a business. 1 These test specifications are listed in the current Special Enrollment Examination Candidate Information Bulletin, which is available for download on the Prometric website: https://www.prometric.com/sites/default/files/IRS/IRS-SEE-Candidate- Information-Bulletin.pdf 19  PassKey EA Review 2024-2025 Edition Sole proprietors often receive Form 1099-NEC from their business customers showing income they were paid for services. The amounts reported on Forms 1099-NEC, along with any other business income, are reported and taxed on the taxpayer’s personal income tax return. Income and expenses from the sole proprietorship are reported on Schedule C, Profit or Loss from Business, of Form 1040. A self-employed individual with net earnings of $400 or more from self- employment is required to pay self-employment tax by filing Schedule SE, Self-Employment Tax, with his Form 1040. Example: Boyd works as an independent plumbing contractor for Texas Construction, Inc. Texas Construction sends Boyd a Form 1099-NEC that shows he received $25,000 for contract work. He also received payments of $7,000 from several individuals for contract work he completed on their homes. Although Boyd did not receive Forms 1099-NEC for the $7,000, he must include the payments as self- employment income, along with the $25,000 from Texas Construction, on his Schedule C. Partnerships A partnership is a relationship that exists between two or more taxpayers who join together to carry on a trade or business. Each taxpayer contributes money, property, labor, or skill and expects to share in the profits and losses of the business. A partnership must file an annual information return to report the income, deductions, gains, and losses from its operations, but the partnership itself does not pay income tax. Instead, any profits or losses “pass through” to its partners, who are then responsible for reporting their respective shares of the partnership’s income or loss on their own returns. Example: Brett and Leia Padgett are father and daughter who co-own and operate Padgett Accounting, LLP. Each is active in the business, and each has a 50% share in partnership interests and profits. The partnership must file Form 1065 to report its income and loss for the year. The partnership must also issue a Schedule K-1 to each partner. In 2023, Padgett Accounting had $80,000 of net ordinary income. Since they share profits and losses equally, Brett and Leia will each report $40,000 of self-employment income on their individual tax returns. A partner’s share of partnership income is reported on page 2 of Schedule E, Supplemental Income and Loss. However, in the event a partnership tax return is audited, by default, the partnership itself will be subject to paying income tax in the event it is determined that it had originally underreported its taxable income on the return. This is referred to as the “centralized partnership audit regime,” or CPAR. If eligible, a partnership can elect out of CPAR on Schedule B-2 (Form 1065). A partnership can only elect out of CPAR if it meets all the following requirements: Must have 100 or fewer partners during the year, and Has only “eligible” partners, which include: o Individuals (natural persons only, neither LLCs nor grantor trusts are considered eligible partners!) o C Corporations or foreign entities classified as corporations o S corporations o Estates of deceased partners (but not bankruptcy estates!) 20  PassKey EA Review 2024-2025 Edition Partnerships with just one non-qualified partner cannot opt-out of the centralized audit regime, even if the partnership has fewer than 100 partners. Example: Hannah, Anthony, and Tristan are partners who run Weeder’s Ceramics, LLC a business that is operated as a partnership. Since the business only has three partners, Weeder’s Ceramics, LLC has always opted-out of the centralized audit regime on Schedule B-2 of the partnership’s Form 1065. However, in 2023, Tristan forms a grantor trust and transfers his partnership interest in Weeder’s Ceramics into his newly-formed trust. The partnership can no longer opt-out of CPAR, because it now has an ineligible partner, namely, the trust that Tristan created to hold his partnership interest. The CPAR requires partnerships to designate a “partnership representative” with the filing of their tax return,2 but the representative is not required to be a partner. The representative can be either an individual or a business entity3 and must have a substantial presence in the United States.4 The partnership representative has the authority to make decisions for the partnership during the course of an audit, and decisions made by the representative are binding on the partnership and all of its partners. Federal law defaults to CPAR for any partnership that does not, or cannot, opt out of CPAR, and requires the partnership to report and pay a tax deficiency resulting from adjustments to the partnership’s tax return. Example: Libertad Energy, LP is a large oil and gas partnership focused on the exploration and production of crude oil and natural gas. Libertad Energy, LP is a large investment partnership with over 2,000 partners. Most of the partners are investors and do not actively work in the business. Libertad Energy cannot elect out of the centralized partnership audit regime, because it has more than 100 partners. Libertad Energy retains a well-known tax attorney, Benjamin Smith, Esq. to represent them in all tax matters. Benjamin Smith is not a partner, but he can be named as the partnership representative on Libertad Energy’s tax return. An unincorporated organization with two or more owners is generally classified as a partnership for federal tax purposes if its members carry on a business and divide its profits. A partnership can look very different depending on how it is structured—it can be anything from a small business run by a married couple to a complex business organization with thousands of general partners and limited partners. A partnership can have an unlimited number of partners and can have partners that are foreign or domestic. A partnership must always have at least one general partner whose actions legally bind the business and who is legally responsible for a partnership’s debts and liabilities. 2 A “partnership representative” is the person that a partnership designates for the tax year as the partnership’s representative, or the person the Internal Revenue Service has appointed to act as the federal partnership representative, pursuant to Section 6223(a) of the Internal Revenue Code. The partnership representative does not have to be an enrolled practitioner. 3 If the representative is a business entity (such as a corporation), a designated individual of the entity must be named to act on the entity’s behalf. 4 A substantial presence is defined as a representative who meets all of the following requirements: (1) they have a U.S. taxpayer identification number; (2) they have a U.S. street address and a telephone number with a U.S. area code; and (3) the partnership representative or designated individual acting on behalf of an entity partnership representative makes themselves available t o meet in person with the IRS in the United States at a reasonable time and place as determined by the IRS in accordance with Treasury Regulation § 301.7605-1. 21  PassKey EA Review 2024-2025 Edition The default legal classification for a partnership is a general partnership where all partners are general partners with each partner jointly and severally liable for the debts and obligations of the partnership. However, a “joint undertaking” merely to share expenses is not automatically a partnership. For example, co-ownership of rental property is usually not considered a formal partnership unless the co- owners provide substantial services to the tenants. Example: Cornell and Dolan are cousins who own a residential rental property together. The property is a passive rental with long-term tenants. Cornell and Dolan each own a 50% interest in the rental. Cornell takes care of any repairs, and Dolan collects and divides the rent. They do not have any other business with each other. The co-ownership of the rental property is not considered a partnership for tax purposes. Instead, they may divide the income and expenses based on their ownership percentages, and each would report his respective share on Schedule E on his individual return. The IRS defines “substantial services” as services that are primarily for the tenant’s convenience, such as daily cleaning, changing linen, or maid service. This would be something like a hotel or bed- and-breakfast. In that case, the rental activity could not be classified as a joint undertaking. Instead, it would be reported on Schedule C, or if the rental was owned and operated by more than one person, it would be classified as a partnership. Example: Orlando and Suzanne are siblings. In 2023, they purchase a Victorian home in downtown New Orleans. They spend a substantial sum to divide the home into four separate units, which they then advertise as a bed-and-breakfast. They offer maid service and daily breakfast to all their guests. The IRS would classify their business as a hotel. Therefore, Orlando and Suzanne would be required to file a partnership return in order to report their earnings and profits. A partnership’s annual tax return is filed on Form 1065, U.S. Return of Partnership Income. Partners are not employees of the business, and they should not be issued a Form W-2. Instead, the partnership must furnish a copy of Schedule K-1 to each of its partners, showing the income and losses allocated to each partner. The return must show the name and address of each partner and the partner’s share of taxable income. The return must be signed by a partner or member.5 A limited partnership (LP) is a partnership that has at least one limited partner in addition to its general partner(s). A limited partnership allows an investor (the limited partner) to own an interest in a business without assuming personal liability or risk beyond the amount of their investment in the partnership. Note: A Limited Partnership (LP) is a state-level entity. Unlike a general partnership (GP), which can be formed merely with a handshake between two persons. In order to form an LP, a Certificate of Limited Partnership or Certificate of Formation must generally be filed with the Secretary of State where the partnership chooses to do business. For example, in order to form an LP in California, a Certificate of Limited Partnership (Form LP–1) must be filed with the California Secretary of State, and the applicable filing fees must be paid. 5 IRC §6063 22  PassKey EA Review 2024-2025 Edition A limited partner generally has no obligation to contribute additional capital to the partnership and, therefore, does not have an economic risk of loss for partnership liabilities. In most states, a limited partner is restricted regarding how active they can be in the management of the partnership. Example: Carter wants to open a dance club. He approaches his aunt, Marisol, for the funds. Marisol agrees to invest in her nephew’s business, but she does not want to be involved in the day-to-day running of the club. After consulting with an attorney, Carter and his aunt form Nightlife Ventures, LP, a limited partnership (LP). Per their partnership agreement, Marisol is a limited partner. She is an investor in the club and contributes $250,000 to establish the club. Carter is an experienced restaurateur and nightlife expert, so he runs the club. Carter is the general partner. A Limited Liability Partnership (LLP) is an entity that is formed under state law and is generally used for specific professional services, such as those offered by a law firm or a CPA firm. Some professionals form an LLP because the option of an LLC may be prohibited in their state for their particular business type.6 For example, in California and New York, LLCs cannot provide certain professional services. Doctors, CPAs, attorneys, veterinarians, and other similar, licensed professionals cannot form an LLC for those particular business activities, but they are allowed to form an LLP and offer these professional services. Typically, an LLP allows each partner to actively participate in management affairs but still provides limited liability protection to each partner. A partner in an LLP generally would not be personally liable for the partnership debts or the malpractice of other partners (or the employees under the management of other partners) and would only be at risk for their own malpractice and/or their interest in the partnership’s assets.7 Example: Dylan and Farad are licensed attorneys in California who decide to go into business with each other. They form an LLP by registering their business with California’s Secretary of State. Once they complete their registration, they open an office and begin accepting new clients. For tax purposes, their business will be taxed as a partnership, and they will be required to file a Form 1065 every year. In a limited liability partnership, the partners enjoy some protection against personal legal liability. Married Couple Businesses and Qualified Joint Ventures Often, a small business is operated by spouses without incorporating or creating a formal partnership agreement. The business is usually considered a partnership, whether or not there is a formal partnership agreement. Note: Federal tax law makes many references to laws specific to a “husband and wife.” These laws also apply to same-sex spouses who are legally married. However, couples that are in civil unions or registered domestic partnerships are not considered “married” for tax purposes. Therefore, these couples cannot elect a “qualified joint venture.” They would be required to file a partnership tax return (Form 1065). 6 With regards to limited partnerships and limited liability partnerships, different states often have significantly different requirements for formation and legal liability. 7 The laws regarding LPs, LLPs and LLCs vary greatly from state-to-state. Information is generally available online through a state’s Secretary of State’s office or the governor’s office. 23  PassKey EA Review 2024-2025 Edition If both spouses materially participate as the only members of a jointly owned and operated business, the business may be treated as a qualified joint venture, or QJV. This allows them to avoid the complexity of filing a partnership return but still allows each spouse to take credit for self-employment earnings from the business for Social Security purposes. Items of business income, gain, loss, deduction, and credit are split between the spouses in accordance with their respective interests in the business. The spouses then file separate Schedules C and separate Schedules SE. This option is available only to married couples who file joint tax returns. A qualified joint venture is available only to businesses owned and operated by spouses as co-owners and not in the name of a state law entity; spousal owners of a limited liability company or a limited partnership generally do not qualify. The IRS specifically excludes state-approved entities (such as LLCs and LLPs) from filing as a qualified joint venture. There is a narrow exception in the law for married couples who live in community property states. Married couples who co-own and operate an MMLLC (multi-member LLC), LLP or other state level created entity) in a community property state may still file on two Schedules C, as long as they agree to file a joint return.8 Furthermore, for a business co-owned by spouses in a community property state, they can elect to report the business activity on two Schedules C, instead of on Form 1065, even if one or both spouses do not materially participate in the business. Example: Jose and Johanna live in Hawaii, where they operate a small business together as husband and wife. Hawaii is not a community property state. They have always treated their business as a qualified joint venture. They file on two Schedule Cs. Later in the year, they decide to form an MMLLC for liability protection. They must now file a partnership return (Form 1065) for their business, starting with the date of formation of the LLC. They can no longer treat their business activity as a qualified joint venture, even if they file jointly. Example: Grant and Evie are married and always file jointly. They live in Texas and run a small grocery store together as a qualified joint venture. During the year, they form a multi-member LLC for liability protection. Since Texas is a community property state, they are allowed to continue reporting their income and loss on two Schedule Cs by making an election to be treated as a Qualified Joint Venture. C Corporations When forming a corporation, prospective shareholders provide money, property, or both in exchange for the issuance of the corporation’s capital stock. A corporation is considered an entity separate from its shareholders and must elect a board of directors who are responsible for oversight of the company. A corporation conducts business, realizes net income or loss, and distributes profits to shareholders. Most major companies are organized as C corporations. C corporations and S corporations (discussed next) are differentiated for tax purposes only. Legally, they are both simply corporations. For tax purposes, however, they are treated much differently. A C corporation may have an unlimited number of shareholders and may be either foreign or domestic. A C corporation must file an annual tax return on Form 1120, U.S. Corporation Income Tax 8There are currently nine community property states: Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico, and Wisconsin. See Rev. Proc. 2002-69, 2002-2 CB 831, for special rules applicable to married couple state law entities in community property states. 24  PassKey EA Review 2024-2025 Edition Return, to report its net income and losses, and pay tax on its income. Its after-tax profits may also be taxable income to its shareholders when distributed as dividends, resulting in double taxation. A C corporation does not receive a tax deduction when it distributes dividends to shareholders, and shareholders cannot deduct any losses of the corporation. A corporation deducts its ordinary and necessary business expenses like any other business, but it is also allowed certain special deductions. C corporations are taxed at a flat rate. Note: The Tax Cuts and Jobs Act permanently eliminated the graduated rates for C Corporations. All C corporations are now taxed at a flat rate of 21%. There is no longer a separate tax rate for personal service corporations (PSC)—all C corporations are taxed at a 21% flat rate, regardless of their size or business activity. The TCJA also permanently repealed the corporate alternative minimum tax (AMT), but the Inflation Reduction Act reintroduced a brand new (and totally different) corporate AMT, effective for tax year 2023, but with major changes; it applies only to certain corporations with average annual book income over $1 billion from the prior three tax years. S Corporations An S corporation is a distinct form of entity, organized as a corporation for legal purposes, but elected with the IRS for tax purposes. For federal income tax purposes, an S corporation is generally not subject to tax; instead, its income, losses, deductions, and credits are passed through directly to its shareholders in a manner similar to a partnership. However, while not common, the S corporation itself may be responsible for income tax on certain built-in gains and passive investment income. We will cover these special taxes that apply to S corporations in a later chapter. An S corporation is required to file an annual income tax return to report its income or loss using Form 1120-S, U.S. Tax Return for an S Corporation. It also reports each shareholder’s applicable share of income or losses on Schedules K-1. The shareholders report the pass-through income or loss on their individual tax returns. As a result, the shareholders of S corporations are able to avoid double federal taxation on their corporate income. S corporations must meet the following requirements: Be a domestic corporation with 100 or fewer “permitted” shareholders (partnerships, C corporations,9 and nonresident aliens are not eligible). Have only one class of stock (voting and nonvoting stock are not considered to be separate classes of stock, as long as they have identical rights to distribution and liquidation proceeds). Not be an ineligible type of corporation (certain financial institutions, insurance companies, and domestic international sales corporations are not eligible for S corporation status). Limited Liability Companies (LLCs) A limited liability company (LLC) is a type of business entity formed under state law by filing articles of organization. Depending upon whether it has a single owner or multiple owners, an LLC will be treated for federal tax purposes either as: A “disregarded entity,” (as described later) As a partnership. A corporation; if the entity elects to be treated as a corporation. 9There is an exception for S corporations who own 100% of another S corporation under certain circumstances, as well as an exception for 501(c)(3) organizations that are organized as corporations. An exempt entity is allowed to own S corporation stock without jeopardizing the S corporation’s status. 25  PassKey EA Review 2024-2025 Edition Most LLCs in the United States are taxed as partnerships. Like the owners of S corporations and partnerships, the members of an LLC can avoid double taxation. An LLC can provide the liability protection of a corporation with the tax benefits of a partnership. Unlike a partnership, none of the members of an LLC are personally liable for its debts. If a multi- member limited liability company (MMLLC) is treated as a partnership for tax purposes, it must file Form 1065 annually, and one of its owners/members must sign the return. A Professional Service Limited Liability Company, or PLLC is a type of limited liability company that is owned and operated by licensed professionals, such as doctors, lawyers, engineers, and CPAs. PLLCs are not available in every state, and have ownership restrictions and can generally only offer services related to its profession. Farmers Farming businesses are primarily engaged in crop production, animal production, or forestry and logging. They may include stock, dairy, poultry, fish, fruit, and tree farms, as well as plantations, ranches, timber farms, and orchards. It is the nature of the activity, and not the entity type that determines whether a business qualifies as a farming business. Congress has enacted many tax laws specific to farming. These laws provide special tax treatment and reflect the highly unpredictable nature of the business. For example, farmers have a different schedule for paying estimated taxes; they may postpone gain or income in certain cases that other businesses cannot; they can deduct a higher percentage of mileage expenses than other businesses, and they are given special tax considerations when disaster strikes. Farming businesses operating as sole proprietorships report income and loss on Schedule F, Profit or Loss from Farming, of Form 1040. Farmers are typically self-employed if they operate a farm or rent farmland from others to engage in the business of farming. Self-employed farmers must also complete Schedule SE to determine self-employment taxes due. A farming business may also be organized as a partnership or a corporation. Even if a farming business is organized as a partnership or corporation, there are many rules that apply to farm businesses that do not apply to any other entity type. Farmers are unique in that respect, and we have dedicated an entire unit to discussing many of the rules that apply specifically to farming activities. Tax-Exempt Organizations (Nonprofit Entities) Internal Revenue Code Section 501(c) outlines the requirements for tax-exempt organizations. They must be organized and operated exclusively for an exempt purpose, and none of their earnings may be used to benefit any private shareholder or individual. Nonprofit organizations may be created as corporations, trusts, or unincorporated associations, but never as partnerships or sole proprietorships. Most charitable organizations must request tax-exempt status by filing Form 1023, Application for Recognition of Exemption. However, churches, including synagogues, temples, and mosques, are treated as tax-exempt by default and do not have to apply for formal exemption, although many do. Most tax-exempt organizations must annually file Form 990, Return of Organization Exempt from Income Tax, to report its income and losses. Many small tax-exempt organizations can file either a Form 990-EZ or the 990-N (e-Postcard) in lieu of Form 990. 26  PassKey EA Review 2024-2025 Edition Form 990 is an informational return only, but a nonprofit organization may be taxed on unrelated business activities on a separate form (Form 990-T) if the organization has unrelated business income. Entity Classification Election Rules Certain business entities may choose how they will be classified for tax purposes by filing Form 8832, Entity Classification Election. An LLC with a single member is classified as a “disregarded entity,” or as not being separate from its owner for income tax purposes, unless the owner files Form 8832 and elects to be taxed as a corporation. Thus, a single-owner LLC owned by an individual is treated as a sole proprietorship, and the owner is subject to the tax on net earnings from self-employment if the LLC conducts a trade or business activity. Because it is a disregarded entity, a single-member LLC that is owned by a corporation or a partnership is included on the entity’s tax return as if it were a division of the corporation or partnership. A single-member LLC cannot be classified as a partnership, because a partnership must have at least two owners. An LLC with at least two members is classified as a partnership by default unless it files Form 8832 and elects to be treated as a corporation (an LLC that wishes to be taxed as an S corporation would file Form 2553, rather than Form 8832). In general, an election to change an LLC’s classification cannot take effect more than 75 days prior to the date the election is filed; nor can it take effect later than 12 months after the date the election is filed (although late elections are possible in some cases). Once a business entity makes an election to change its classification, it generally cannot change the election again within five years (60 months). The 60-month limitation does not apply if the previous election was made by a newly formed eligible entity and was effective on the date of formation. Example: Kiana and Garrick are siblings and own their own business, K&G LLC, which is taxed as a partnership. A year after they began business operations, they decide that they want to try and attract foreign investors to their business. They decide to change K&G’s tax classification to be taxed as a C corporation, so they file Form 8832. The change is accepted by the IRS, and the business will now file as a C Corporation on Form 1120. At this point, if Kiana and Garrick change their minds and want their business to go back to being classified as a partnership again, they would have to wait at least 60 months (five years). Recordkeeping for Businesses Adequate records help a business to monitor its operations, verify income and expenses, and support expenses on its tax return. Except in a few cases, the law does not require a business to keep any specific kind of records or to use a particular recordkeeping system, so long as the system clearly shows a business’ income and expenses. A recordkeeping system should include a summary of business transactions, which is usually made in the taxpayer’s books, such as accounting journals and ledgers. The books must show the business’ gross income, as well as its deductions and credits. Additional documents must be kept to support these entries. These include sales slips, paid bills, invoices, receipts, deposit slips, canceled checks, credit card charge slips, cash register tapes, invoices, mileage logs, and phone records. 27  PassKey EA Review 2024-2025 Edition Electronic records are acceptable so long as they provide a complete and accurate record of data that is accessible to the IRS in a legible format. They are subject to the same controls and retention guidelines as those used for the taxpayer’s original hard copy books and records. A business must keep records as long as they are needed for the administration of any provision of the Internal Revenue Code. Usually, this means the business must keep records long enough to support income and deductions until the statute of limitations for a related tax return has expired. Definition: A “statute of limitation” is a time period to review and analyze tax-related issues by the IRS. The Internal Revenue Code requires that the IRS must assess, refund, credit, and collect taxes within specific time limits known as the statute of limitations. When they expire, the IRS can no longer assess additional tax, allow a claim for refund by the taxpayer, or take collection action. Generally, a business must keep records for at least three years from when a tax return was due or was filed, whichever is later. If a business has employees, it must keep all employment tax records for at least four years. Taxpayers must keep records relating to property until the statute of limitations expires for the year in which the property is sold or otherwise disposed of. These records are needed to figure depreciation, amortization, or depletion deductions, and to figure basis for computing gain or loss. A taxpayer may need to keep records relating to the basis of property even longer since they may be important in determining the basis of replacement property. Business funds should be kept separate from personal funds. The IRS is more likely to audit a business and deny deductions and losses if there is no clear separation between business and personal expenses. A separate bank account for business-related transactions is advisable, with business- related bills paid from it rather than from a personal account. Financial Statements Financial statements are the formal records of a business’ financial activities. There are many types of financial statements, but the two most common ones used for tax reporting purposes are the income statement and the balance sheet. Income Statement: The income statement is also called the “profit and loss” statement. It indicates the business’s revenue, expenses, and net income or loss during a period, such as a month, quarter, or fiscal or calendar year. Balance Sheet: The balance sheet is a summary of a business’ assets, liabilities, and equity on a specific date, such as at the end of its fiscal year. A balance sheet provides a “snapshot” of the business’s financial condition. Balance sheet accounts are carried forward from year to year, unlike income statement accounts, which are closed out at year-end and only reflect business operations within a specified period. Employer Identification Number (EIN) An employer identification number is used for reporting purposes. Unlike Social Security numbers that are assigned to individuals, EINs are assigned to business entities. If a sole proprietor has no employees, the business owner is normally not required to obtain an EIN. An EIN can be requested by a sole proprietor who simply wishes to protect their Social Security number for privacy reasons. If a sole proprietor decides to convert to a different business entity type, 28  PassKey EA Review 2024-2025 Edition such as a partnership or corporation, a new EIN would be required for each separate entity. A business must apply for an EIN if any of the following apply: The business pays employees, The entity operates as a corporation, exempt organization, trust, estate, or partnership, The business files any of these tax returns: o Employment taxes (payroll taxes) o Excise tax10 o Alcohol, tobacco, and firearms The business withholds taxes paid to a nonresident alien The business establishes a pension, profit-sharing, or retirement plan A new EIN is required for any of the following changes: When a sole proprietor or partnership decides to incorporate, or when a sole proprietor takes on a partner and becomes a partnership When a partnership becomes a sole proprietorship (for example, when one partner dies) When a sole proprietor files for bankruptcy under Chapter 7 or Chapter 11 When a taxpayer terminates one partnership and begins another partnership When a business establishes a pension, profit-sharing, or retirement plan The individual owner dies, and the business is taken over by the estate (in this case, the new EIN would be the EIN of the estate). A business does not need to apply for a new EIN in any of the following instances: Merely to change the name or address of a business To change the location or add more business locations (e.g., additional stores or branches of the same entity) If a sole proprietor operates multiple businesses (including stores or branches of the same business) Further, a single-member limited liability company (LLC) classified as a disregarded entity may use the owner’s SSN or EIN and does not need a separate EIN, unless the business is required to file employment or excise tax returns. Most taxpayers can apply for an EIN online or paper-file Form SS-4, Application for Employer Identification Number. Specific Reporting Requirements Businesses are subject to a number of reporting requirements, including the following: Form W-2: A business must complete and file with the Social Security Administration Forms W-2, Wage, and Tax Statement, showing the wages paid and taxes withheld for the year for each employee. A copy of the W-2 must be given to each current and former employee who received taxable wages or salaries during the year by no later than January 31 of the following year. Businesses have a single filing deadline for all Form W-2s (January 31). 10Excise taxes are taxes paid when purchases are made on a specific good, such as gasoline. Excise taxes are often included in the price of the product. There are also excise taxes on certain activities, such as on gambling, indoor tanning, or on highway usage by trucks. Excise taxes are reported on Form 720, Quarterly Federal Excise Tax Return. 29  PassKey EA Review 2024-2025 Edition This is true for both employee and IRS copies, or whether filing on paper or electronically. Large employers are typically required to use e-file, and failing to do so may incur a penalty. Note: Under a new e-file mandate implemented by the Taxpayer First Act any business filing 10 or more returns or statements in 2024 (for the 2023 tax year) will be required to file these forms electronically. This mandate includes Form 1099 and W-2. The IRS developed an Internet portal on January 25, 2023 that allows taxpayers to electronically file and distribute Forms 1099. The portal is named the Information Returns Intake System (IRIS). Form W-4: When a business hires an employee, the employee must complete a Form W-4, Employee’s Withholding Certificate. The Form W-4 reports the employee’s marital status and the number and type of dependents (qualifying children or other dependents). In addition, at the option of the employee, the employee can inform the employer of taxable income they expect to have outside of their job, (if applicable) the expected amount of their itemized deductions, and any requested additional withholding. If an employee fails to complete a Form W-4, the employer must withhold federal income taxes from his wages as if he were single and taking the standard deduction. A business may have to file multiple types of information statements. Form 1099-NEC: (payments to independent contractors): A business must report nonemployee compensation of $600 or more paid during the year to certain independent contractors that provided services by providing a Form 1099-NEC by January 31 of the following year. Form 1099-MISC: Amounts that are reported on the 1099-MISC include: Payments of $600 or more for rents, prizes and awards, crop insurance proceeds, and certain medical and health care payments, Royalties over $10, and Gross proceeds paid to an attorney’s office, when the total amount is $600 or more.11 Except for attorneys, payments to corporations are generally exempt from Form 1099 reporting requirements. Forms 1099 should only be used for payments that are made in the course of a trade or business. Personal payments are not reportable. Example: Madeline hires Jonah, a professional house painter, to paint the exterior of her main home. The job costs $3,500. Madeline is not required to report the payment on a 1099-NEC, because it is for her personal residence. Since it was a personal payment, she cannot deduct the cost on her income tax return. However, Jonah is still required to report the income on his income tax return. The following year, Madeline hires Jonah again, but this time, to paint the interior of her business office, which she owns. The painting job costs $2,000. Since the cost is a business expense, Madeline is required to issue a Form 1099-NEC to Jonah. A business should only include payments made by cash, check, ACH transfer, or other direct means on Form 1099-MISC or 1099-NEC. Credit card payments, including third-party network transactions, must be reported on Form 1099-K by the payment settlement entity and are not subject to reporting on Form 1099-MISC or 1099-NEC. 11An attorney’s office is subject to the 1099 reporting requirements, even when the attorney/law firm is an incorporated entity. This is contrary to the normal 1099 rules, as corporations are generally exempt. This exception has been tested on prior exams. 30  PassKey EA Review 2024-2025 Edition Form 1099-K: The Form 1099-K, Payment Card and Third-Party Network Transactions, is an IRS information return used by payment settlement entities (like PayPal, Square and Stripe) to report online payment transactions. The reporting requirement for Form 1099-K, Payment Card and Third- Party Network Transactions, was reduced to $600 by the American Rescue Plan Act of 2021. However, on November 21, 2023, the IRS issued Notice 2023-74, announcing an additional delay in the new 1099-K reporting threshold; this means that the prior threshold remains in effect for 2023.12 The 1099-K reporting threshold in 2023 is: (1) $20,000 in gross earnings or (2) 200 or more transactions. Example: Stuart is a full-time bank teller who also works as a rideshare driver on the weekends. Stuart receives a Form 1099-K for his driving services, since the payments made to him are processed by a third-party network. In 2023, Stuart makes $21,500 driving for the rideshare company. He gets a 1099- K because he made over $20,000 and provided more than 250 rides to passengers during the year. The 1099-K includes a breakdown of his annual gross earnings. He would report this income on Schedule C, and also deduct his business expenses. Form 1099-INT: A business that is not in a line of business that pays interest as part of its regular activities (such as a bank or a credit union) must generally report interest paid to any single individual taxpayer when the total is $600 or more for the year. For banks and similar institutions, the reporting requirement threshold is $10 or more per year. Other examples of information returns include, but are not limited to, the following: Form 1099-R: (distributions from retirement plans and pensions) Form 1099-DIV: (dividends, including those from stocks or mutual funds) Form 1099-B: (stock or mutual fund sales and other transactions by brokers) Form 1099-S: (proceeds from real estate transactions) Form 1099-C: (canceled debt) Form 1099-A: (acquisition or abandonment of secured property) Form 1099-PATR: (taxable distributions received from cooperatives) Form 8300, Report of Cash Transactions over $10,000: When a business receives a cash payment of more than $10,000 from one transaction (or two or more related transactions), it must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, within 15 days after they receive the cash.13 This type of transaction is also called a “designated reporting transaction.”14 A business must also provide a written statement to each person or customer named on any Form 8300 that is filed. The statement must be provided to the customer no later than January 31 of the following year. 12 Per IRS Fact Sheet FS 2023-27, the IRS is planning for a threshold of $5,000 for calendar year 2024 as part of a phased-in approach to implementing the $600 reporting threshold under the American Rescue Plan Act. At the time of this book’s printing, the IRS has not released any additional guidance on this phased-in approach. 13 For the purposes of this rule, “cash” includes the coins and currency of the United States, cashier’s checks (but generally only when the amount of the cashier’s check is $10,000 or less), bank drafts, traveler’s checks, as well as cash in a foreign currency. “Cash” does not include bank wire transfers, credit card transactions, ACH transactions, or amounts paid with personal checks. 14 The information contained on the Form 8300 assists law enforcement in its anti-money laundering efforts. 31  PassKey EA Review 2024-2025 Edition Example: Elko’s Used Autos, LLC is a small, family-owned car dealership. On January 6, 2023, Jennifer buys a used car from Elko’s Used Autos and pays $17,000 in cash. The dealership asks Jennifer for her driver’s license and verifies her identification, in order to get the necessary information to complete Form 8300. Elko’s Used Autos must file Form 8300 no later than January 21, 2023 (15 days later). The dealership must also send a statement to Jennifer by January 31, 2024 (the following year). If a business receives over $10,000 in cash during two or more “related” transactions, the business must also treat the transactions as a single transaction and report the payments on Form 8300. The Form 8300 reporting requirement only applies to business transactions. Sales of personal-use property that is sold in a private sale are typically not subject to any type of formal reporting. Example: Sheena is an elementary school teacher. She decides to sell her personal vehicle. She places an ad in her local newspaper listing her car for $12,500. She finds a buyer for the car, who pays her $12,500 in cash a week later. Sheena does not have to report the sale on Form 8300 because she is not a professional car dealer, and the transaction was not a business transaction. Employee and Worker Classification Because businesses are responsible for withholding and paying income, employment, and FUTA taxes, as well as reporting payments to independent contractors, they must accurately determine whether a person they pay is an independent contractor or an employee. A business is generally not required to withhold or pay taxes in connection with payments to independent contractors. However, it must understand the relationship that exists with each person it pays to perform services. A person performing services for a business may be: An independent contractor An employee A statutory employee A statutory nonemployee The IRS evaluates three primary characteristics to determine the relationship between a business and workers it pays for services: Behavioral Control: Covers whether the business has a right to direct or control how the work is done. Financial Control: Covers whether the business has a right to direct or control the financial and business aspects of the worker’s job. Factors include how the worker is paid, whether expenses are reimbursed, and whether tools and supplies are provided. Type of Relationship: Relates to how the worker and the business owner perceive their relationship, such as whether there are written contracts or employee-type benefits, such as vacation pay or a retirement plan. Whether a person is classified as an employee or an independent contractor depends on the facts and circumstances of each individual case.15 If the determination of whether a worker is an employee or independent contractor is still unclear after weighing the various facts and circumstances of an 15Many individual states have more stringent regulations regarding how a worker is classified as an employee. Please note the EA exam tests federal tax law rules only. 32  PassKey EA Review 2024-2025 Edition individual case, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, can be filed with the IRS. The Form SS-8 may be filed by either the business or the worker. The IRS will review the case to officially determine the worker’s status. Employers who misclassify workers as independent contractors rather than employees may face substantial tax penalties for failing to pay employment taxes and failing to file payroll tax forms. An independent contractor that is considered self-employed pays self-employment tax if net earnings from self-employment are $400 or more. The contractor then reports self-employment income on Schedule C (Form 1040). There is generally no tax withholding on income received as a self-employed individual, as long as they provide their tax identification number to the payor. An independent contractor may be required to make quarterly estimated tax payments. Backup Withholding: If a business does not request a Social Security number or a taxpayer identification number for a payee, such as an independent contractor, it must withhold federal income taxes at a 24% rate in 2023. U.S. source income received by a foreign person (a nonresident alien) is subject to a withholding rate of 30% unless a lower tax treaty rate applies. Example: Adam, a licensed electrician, submits a job estimate to a housing complex for electrical work at $36 per hour for 400 hours. He is to receive milestone payments every two weeks for the next ten weeks. Adam will receive $14,400, regardless of whether he works more or less than 400 hours to complete the work. He also performs electrical installations under contracts with other companies that he obtains through ads placed online. Adam would likely be classified as an independent contractor. Example: Katrina is a salesperson employed full-time by an auto dealership. She is on duty in the showroom on certain assigned days and times. She uses lists of prospective customers that belong to the dealership. She develops leads and reports results to the sales manager. Because of her experience, she requires minimal assistance in closing and financing sales. She is paid a commission and is eligible for bonuses offered by the dealership. The business also pays the cost of her health and group-term life insurance. Katrina is classified as an employee. Statutory Employees Some workers are classified as statutory employees. Statutory employees are unique because they are issued Forms W-2 by their employers but report their wages, income, and allowable expenses on Schedule C, just like self-employed taxpayers. If a person is a statutory employee, the “statutory employee” in box 13 on their Form W-2 should be checked. Statutory employees are usually salespeople or other employees who work on commission. The difference is that statutory employees are not required to pay self-employment tax, because their employers must treat them as employees for Social Security tax purposes. Examples of statutory employees include: Certain commissioned truck drivers, if they distribute meat products, vegetable products, bakery items, or drinks (other than milk) or pick up or deliver laundry or dry-cleaning for a specific business. Full-time life insurance salespeople, Certain home workers who perform work on materials or goods furnished by the employer. 33  PassKey EA Review 2024-2025 Edition A full-time traveling salesperson who represents a business and submits orders on behalf of the business from various suppliers, retailers, contractors, or businesses such as hotels and restaurants. Example: Avery is a full-time life insurance salesperson working for Provident Life Insurance Company. Avery sells life insurance and annuity contracts, and he works out of a business office that he rents himself. Provident Life Insurance issues Avery a Form W-2 with the box for “statutory employee” checked. Avery will report his income and loss on Schedule C, but a Schedule SE will not be generated by his software, because Social Security and Medicare taxes have already been withheld and remitted to the IRS by his employer. Avery is classified as a statutory employee (see W-2 image). Statutory Nonemployees There are three categories of statutory nonemployees: direct sellers, licensed real estate agents and certain companion sitters. They are treated as self-employed for federal tax purposes, including income and employment taxes, if: Payments for their services are directly related to sales, rather than to the number of hours worked, and Services are performed under a written contract providing that they will not be treated as employees for federal tax purposes. Companion sitters who are not employees of a companion sitting placement service are generally treated as self-employed, unless the individual for whom the services are performed has the right to direct and control the sitter. 16 Compensation for a statutory nonemployee is reported on Form 1099-NEC. The taxpayer then reports the income on Schedule C. 16Companion care is a form of non-medical, in-home care for older adults or people with disabilities. Additional guidance can be found in Chief Counsel Advice 201633034. 34  PassKey EA Review 2024-2025 Edition Example: Eugenia works as a full-time real estate agent for Trusty Realty Services. She visits the real