TCP Area II: Entity Tax Compliance

C corporations, S corporations, partnerships, and trusts & estates: computing taxable income, basis, distributions, and the key compliance schedules

C corporation taxable income §11 / §1501

A C corporation is a separate taxpayer that files Form 1120 and pays tax on its own taxable income at a flat 21% rate (no brackets, no preferential rate on the first dollar). Taxable income starts from the corporation's book income and is reconciled to tax through the Schedule M-1 (or M-3) adjustments. Mastering this reconciliation is the heart of corporate compliance: the exam loves to give you book net income and ask you to back into taxable income.

The flat 21% rate

The corporate rate has been a flat 21% since the 2017 Act, applied to the full amount of taxable income. There is no graduated schedule and no separate capital-gains rate for corporations (net capital gain is simply included in ordinary taxable income and taxed at 21%).

Book-to-tax reconciliation: Schedule M-1

Schedule M-1 reconciles book net income (per the financial statements) to taxable income on the return. You start with book income, then add back items that reduced book income but are not deductible (or not fully deductible) for tax, and subtract items that increased book income but are not taxable. Corporations with total assets of $10 million or more file the more detailed Schedule M-3 instead, which separates permanent and temporary differences, but the conceptual flow is identical.

Common M-1 adjustment	Direction	Why
Federal income tax expense	Add to book income	Not deductible in computing taxable income
50% of meals (nondeductible half)	Add back	Only 50% of qualifying meals is deductible
Fines & penalties paid to government	Add back	Never deductible (§162(f))
Excess of book over tax depreciation	Subtract	Tax (MACRS/§179/bonus) often exceeds book
Tax-exempt interest (e.g. municipal bonds)	Subtract	In book income but excluded for tax
Dividends-received deduction (DRD)	Subtract	Tax-only deduction, never on the books
Life insurance proceeds on key employee	Subtract	Tax-exempt receipt
Premiums on key-person life insurance	Add back	Nondeductible expense

M-1 direction check If an item is an EXPENSE on the books but NOT deductible for tax, ADD it back. If an item is INCOME on the books but NOT taxable, SUBTRACT it. The DRD is the oddball: it is a tax-only deduction that never appears on the books, so it is always a subtraction.

Schedule M-2: retained earnings

Schedule M-2 reconciles unappropriated retained earnings at the beginning of the year to the end of the year. The basic flow is: beginning retained earnings, plus net income per books, less dividends and other distributions, plus or minus other adjustments, equals ending retained earnings. M-2 tracks the equity account, not taxable income, so do not confuse it with the M-1.

Trap: Federal income tax expense is added back on M-1 because it is nondeductible, but the corporation still reduces book retained earnings on M-2 by the net income figure that already absorbed that expense. Keep the two schedules separate: M-1 fixes taxable income, M-2 reconciles equity.

Corporate special deductions & limits §243 / §170 / §1212

Once taxable income before special deductions is computed, a C corporation claims several deductions that carry their own limitations. These are heavily tested because each has a different cap, a different carryover period, and ordering rules that interact.

Dividends-received deduction (DRD)

To soften triple taxation when one corporation owns stock in another, §243 grants a deduction for a percentage of dividends received from a domestic taxable corporation. The percentage depends on the recipient's ownership of the payer:

Ownership of payer	DRD percentage
Less than 20%	50%
20% to less than 80%	65%
80% or more (affiliated group)	100%

The DRD is also subject to a taxable-income limitation: the deduction generally cannot exceed the DRD percentage multiplied by taxable income (computed without the DRD, any NOL, capital loss carryback, or §199A). For a 50% dividend, the limit is 50% of that taxable income; for a 65% dividend, it is 65% of that taxable income.

The DRD limitation exception: If taking the FULL DRD (without the taxable-income limit) creates or increases a net operating loss, the limitation does NOT apply and the full DRD is allowed. Always compute the full DRD first; if it produces an NOL, stop. If it does not, then apply the taxable-income cap. This sequencing is a classic MCQ.

Charitable contributions

A corporation's charitable-contribution deduction is limited to 10% of taxable income computed before the charitable deduction, the DRD, any capital loss carryback, and the NOL carryback. Contributions exceeding the 10% ceiling carry forward 5 years. Accrual-basis corporations may elect to deduct contributions authorized by the board by year end and paid within 3.5 months (by the 15th day of the fourth month).

Capital gains and losses

Corporations net capital gains with ordinary income at 21% (no preferential rate), but capital LOSSES are deductible only against capital GAINS, never against ordinary income. A net capital loss carries back 3 years and forward 5 years, always as a short-term capital loss. This is different from individuals, who deduct up to $3,000 of net capital loss against ordinary income and carry forward indefinitely.

Net operating losses (NOLs)

For NOLs arising in tax years beginning after 2017: no carryback, indefinite carryforward, and the deduction in any year is limited to 80% of taxable income (computed before the NOL deduction). Older pre-2018 NOLs that remain may still offset 100% of taxable income and follow legacy carryback rules.

Business interest limitation §163(j)

The deduction for business interest expense is generally limited to the sum of business interest income plus 30% of adjusted taxable income (ATI), plus floor-plan financing interest. Disallowed interest carries forward indefinitely. Small businesses meeting the gross-receipts test (average annual gross receipts at or below the inflation-adjusted threshold, $30 million for 2024) are exempt.

Ordering of corporate special deductions Taxable income before special deductions → subtract DRD → subtract charitable (10% ceiling) → subtract NOL (80% cap on post-2017 losses). Because charitable is computed before the DRD and the NOL ceilings reference each other, work the limits in the order the Code prescribes rather than netting everything at once.

Corporate AMT / CAMT & estimated tax §55 / §6655

The 2017 Act repealed the old corporate AMT, but a new minimum tax was added for the very largest corporations. Most corporations a candidate will see on the exam are NOT subject to it, and the answer is often to recognize that fact.

Corporate alternative minimum tax (CAMT)

Effective for tax years beginning after 2022, the CAMT imposes a 15% minimum tax on adjusted financial-statement income (AFSI) of an applicable corporation. A corporation is "applicable" only if its average annual AFSI over a 3-year period exceeds $1 billion (a lower $100 million threshold applies to certain U.S. members of large foreign-parented groups). The tax is the excess of 15% of AFSI over regular tax plus the BEAT.

Exam reality: The vast majority of corporations are NOT applicable corporations and owe no CAMT. If a fact pattern gives modest AFSI (well under $1 billion), the CAMT simply does not apply. Do not compute a tentative minimum tax for a small or mid-size company.

Estimated tax payments

Corporations must pay estimated tax in four installments (15th day of the 4th, 6th, 9th, and 12th months of the tax year) to avoid a §6655 underpayment penalty. The required annual payment is the LESSER of:

100% of the current-year tax, or
100% of the prior-year tax (the prior-year safe harbor).

Large corporation rule: A corporation with taxable income of $1 million or more in any of the three preceding years may use the prior-year safe harbor ONLY for its first installment; the remaining installments must be based on the current year. A corporation with no prior-year liability, a short prior year, or a prior year that was not a full 12 months cannot use the prior-year safe harbor.

Penalty taxes: AET and PHC tax

Two penalty taxes discourage corporations from accumulating earnings to shelter shareholders from the dividend tax:

Accumulated earnings tax (AET): a 20% penalty on earnings accumulated beyond the reasonable needs of the business. A lifetime accumulated-earnings credit of $250,000 ($150,000 for personal-service corporations) is allowed. It is not self-assessed; the IRS imposes it on audit.
Personal holding company (PHC) tax: a 20% penalty on undistributed PHC income. A corporation is a PHC if 5 or fewer individuals own more than 50% of stock (the ownership test) AND at least 60% of adjusted ordinary gross income is passive PHC income such as dividends, interest, rents, and royalties (the income test). Unlike the AET, the PHC tax is self-assessed on Schedule PH.

Distinguish: AET and PHC tax cannot both apply to the same corporation in the same year. The PHC tax is self-assessed and ownership-driven; the AET is IRS-imposed and intent-driven (accumulating to avoid the shareholder-level tax).

S corporation eligibility & election §1361 / §1362

An S corporation is a flow-through entity: it generally pays no entity-level income tax and passes income, deductions, and credits to shareholders on Schedule K-1 of Form 1120-S. To enjoy that treatment, the corporation must meet strict eligibility rules and make a valid election.

Eligibility requirements (§1361)

Must be a domestic corporation (or eligible domestic entity).
No more than 100 shareholders (family members may elect to be counted as one).
Only eligible shareholders: individuals (U.S. citizens or residents), estates, and certain trusts (grantor trusts, QSSTs, ESBTs). No corporations, no partnerships, no nonresident aliens.
Only one class of stock (differences in voting rights are permitted, but not differences in distribution or liquidation rights).

S corp eligibility, the four gates Domestic corporation · ≤100 shareholders · eligible shareholders only (NO C corps, NO partnerships, NO nonresident aliens) · ONE class of stock. Fail any one gate and the S election is invalid or terminates.

Making the election (§1362)

The corporation files Form 2553 with the consent of all shareholders. To be effective for the current tax year, the election must be filed by the 15th day of the third month of that year; an election filed later is effective the following year (relief for a late election may be available). Anyone who was a shareholder during the part of the year before the election must also consent.

Termination of the S election

An S election ends in any of three ways:

Voluntary revocation by shareholders holding more than 50% of the stock (voting and nonvoting). A revocation made by the 15th day of the third month is effective for the whole year; otherwise it is effective the following year (or on a stated prospective date).
Ceasing to qualify, e.g. exceeding 100 shareholders, issuing a second class of stock, or admitting an ineligible shareholder. Termination is effective on the date of the disqualifying event.
Excess passive investment income: if the corporation has accumulated C corporation E&P AND passive investment income exceeds 25% of gross receipts for 3 consecutive years, the election terminates at the start of the fourth year.

Five-year rule: After an S election terminates, the corporation generally cannot re-elect S status for 5 years without IRS consent. A termination that occurs mid-year creates an "S short year" and a "C short year," with income allocated between them.

S corporation income, basis & AAA §1366–1368

Because the S corporation flows income through to its owners, the compliance work centers on three moving parts: what items pass through, how each shareholder's stock basis changes, and how distributions are taxed.

Separately vs nonseparately stated items

Like a partnership, an S corporation reports ordinary business income (loss) as a single nonseparately stated number, then breaks out items whose character or limitation matters at the shareholder level. Separately stated items include capital gains and losses, §1231 gains/losses, dividend and interest income, charitable contributions, §179 expense, and tax credits. Each flows to the K-1 and retains its character in the shareholder's hands.

Shareholder STOCK basis ordering

A shareholder adjusts stock basis each year in a fixed order:

Increase for capital contributions and for the shareholder's share of income (both separately and nonseparately stated, including tax-exempt income).
Decrease for distributions (but not below zero).
Decrease for nondeductible expenses, then for the share of deductions and losses (but not below zero).

Losses are deductible only up to the sum of stock basis plus direct shareholder loan (debt) basis. An S shareholder, unlike a partner, does NOT get basis for the corporation's own third-party debt; only a direct loan FROM the shareholder TO the corporation creates debt basis. Losses suspended for lack of basis carry forward indefinitely until basis is restored.

The Accumulated Adjustments Account (AAA)

The AAA is an entity-level account that tracks the cumulative undistributed income that has already been taxed to shareholders while the S election has been in effect. For an S corporation that has accumulated C corporation E&P, distributions are taxed in this order:

From AAA: tax-free to the extent of the shareholder's stock basis (return of previously taxed income).
From accumulated E&P: taxed as a dividend.
Return of remaining stock basis: tax-free.
Excess over basis: capital gain.

An S corporation that has NEVER been a C corporation has no accumulated E&P, so distributions are simply tax-free to the extent of basis and capital gain beyond that, and the AAA ordering with E&P never comes up.

AAA is NOT stock basis: AAA is a single corporate-level account (it can even go negative) and ignores tax-exempt income; stock basis is tracked per shareholder, includes tax-exempt income, and can never drop below zero. A distribution is tax-free based on the SHAREHOLDER'S basis, while AAA determines whether the distribution is treated as previously taxed income or as a dividend out of E&P. Keep the two accounts separate.

Built-in gains (BIG) tax

A corporation that converts from C to S status may owe the built-in gains tax: a 21% entity-level tax on net built-in gains (appreciation that existed at the conversion date) recognized during the 5-year recognition period. It is the main situation in which an S corporation itself pays an income tax.

Partnership formation & basis §721 / §722 / §752

Partnerships (and most LLCs) are flow-through entities filing Form 1065. The formation rules are designed to let partners pool property tax-free, with the gain deferred inside each partner's basis.

Nonrecognition on contribution (§721)

Generally no gain or loss is recognized when a partner contributes property to a partnership in exchange for a partnership interest, regardless of the percentage interest received. There is no “80% control” requirement like the corporate §351 rule; §721 is broader.

Partner's OUTSIDE basis (§722)

A contributing partner's initial outside basis equals:

Cash contributed, plus
The adjusted basis (not fair value) of property contributed, plus
The partner's share of partnership liabilities, minus
Any of the partner's own liabilities assumed by the partnership (treated as a deemed cash distribution).

Inside vs outside basis: Outside basis is the partner's basis in the partnership interest. Inside basis is the partnership's basis in its assets. At formation they are equal in aggregate; they diverge over time as interests are sold or distributions occur.

Effect of liabilities (§752)

A change in a partner's share of partnership liabilities is treated as a cash flow that adjusts basis:

An increase in a partner's share of liabilities is a deemed cash contribution (increases outside basis).
A decrease is a deemed cash distribution (decreases outside basis, and can trigger gain if it exceeds basis).

Recourse liabilities are allocated to the partners who bear the economic risk of loss; nonrecourse liabilities are generally shared by profit-sharing ratios. This sharing matters: a contributing partner who is relieved of a mortgage retains a share of it through the partnership, so only the net relief reduces basis.

Built-in gain property and holding period

When a partner contributes appreciated property, §704(c) requires the built-in gain (or loss) at contribution to be allocated back to the contributing partner when the property is later sold or depreciated, so the pre-contribution gain is not shifted to the other partners. The partner's holding period tacks: the partnership inherits the contributor's holding period for the property, and the partner generally tacks the property's holding period to the partnership interest for capital assets and §1231 property.

Services are different: Contributing SERVICES in exchange for a capital interest is TAXABLE. The partner recognizes ordinary compensation income equal to the fair value of the capital interest received, and that amount becomes the partner's basis. §721 nonrecognition covers contributions of property, not labor.

Partnership operations & distributions §704 / §731 / §751

During operations the partnership computes ordinary business income and separately stated items, passes them to partners on the K-1, and tracks each partner's basis. Distributions, current or liquidating, then draw down that basis.

Separately stated items & the K-1

The partnership reports nonseparately stated ordinary business income (loss) plus separately stated items (capital gains/losses, §1231 items, charitable contributions, §179 expense, interest and dividend income, credits, and so on). Each partner reports a distributive share on Schedule K-1 and retains the character of each item.

Substantial economic effect (§704(b))

Special allocations among partners are respected only if they have substantial economic effect, meaning they are reflected in the partners' capital accounts and the economics, not just the tax result, follow the allocation. Otherwise income is reallocated according to the partners' interests in the partnership.

Guaranteed payments

A guaranteed payment is compensation to a partner for services or use of capital that is determined without regard to partnership income. It is deductible by the partnership (in computing ordinary income) and is ordinary income to the receiving partner. Crucially, you ignore the partner's profit/loss sharing percentage: the full guaranteed payment is income to that partner regardless of how the residual is split.

Loss limitation

A partner may deduct a distributive share of loss only up to outside basis (which includes the partner's share of partnership liabilities, unlike an S shareholder). Losses beyond basis are suspended and carry forward until basis is restored. The at-risk and passive-activity rules apply as additional layers after the basis test.

Distributions: current vs liquidating

	Current (nonliquidating)	Liquidating
Gain recognized?	Only if cash distributed exceeds outside basis	Only if cash distributed exceeds outside basis
Loss recognized?	Never	Allowed if ONLY cash, unrealized receivables, and inventory are received and basis remains
Basis of property received	Carryover basis, limited to remaining outside basis after cash	Remaining outside basis (after cash) is allocated to the property; the interest is fully liquidated
Effect on outside basis	Reduced by cash and property basis (not below zero)	Reduced to zero; the interest ends

In a current distribution, cash reduces basis first, then property takes a carryover basis capped at the partner's remaining outside basis. In a liquidating distribution, the partner's entire remaining outside basis is absorbed into the assets received, so the interest is zeroed out.

Hot assets (§751)

Hot assets are unrealized receivables and (substantially appreciated) inventory. When a partner sells an interest or receives a disproportionate distribution, §751 converts what would be capital gain into ordinary income to the extent attributable to hot assets, preventing partners from cashing out ordinary income at capital rates.

§754 / §743(b) adjustments

Normally a buyer of a partnership interest steps up outside basis but the partnership's inside basis is unchanged, creating a mismatch. A §754 election lets the partnership adjust the inside basis of its assets (under §743(b) for a transfer, or §734(b) for certain distributions) so the new partner's inside and outside basis align. The election, once made, applies to all future transfers until revoked.

Trusts & estates income tax §641–663 / Form 1041

A trust or estate is a separate income-tax-paying entity that files Form 1041. It works as a modified conduit: income distributed to beneficiaries is taxed to them, while income retained is taxed to the fiduciary entity. Do not confuse this fiduciary INCOME tax with the separate transfer (estate) tax on Form 706.

Simple vs complex trusts

A simple trust must distribute all of its income currently, makes no charitable contributions, and distributes no corpus (principal). It is entitled to a $300 exemption.
A complex trust is anything else: it may accumulate income, distribute principal, or make charitable gifts. Its exemption is $100. (An estate's exemption is $600.)

Distributable net income (DNI)

DNI is the linchpin of fiduciary taxation. It serves two functions at once:

It is the ceiling on the income-distribution deduction the entity may claim, and
It is the ceiling on, and the character source of, the amount taxable to beneficiaries.

DNI is roughly taxable income before the distribution deduction and exemption, with adjustments: tax-exempt interest is added back (net of related expenses), and capital gains allocable to corpus are generally excluded. The character of the income (interest, dividends, tax-exempt, capital) carries through DNI to the beneficiaries in proportion.

Income-distribution deduction and the conduit

The entity deducts the lesser of DNI (net of tax-exempt income) or the amount actually distributed. Beneficiaries then include their share, capped by DNI and carrying its character on their own K-1. Income that is NOT distributed stays with the trust or estate and is taxed at the entity level.

Compressed trust brackets

Undistributed income is taxed at the trust and estate rate schedule, which is highly compressed: the top 37% bracket and the 20% capital-gains rate are reached at a very low income level (a few thousand dollars). The 3.8% net investment income tax also applies at that low threshold. This compression is why trusts often distribute income out to beneficiaries in lower brackets.

Grantor trusts

Under the grantor-trust rules (§671–679), if the grantor retains certain powers or interests (revocability, the right to income, control over beneficial enjoyment), the trust is disregarded for income tax and all income is taxed to the grantor, not the trust or the beneficiaries.

Estate income tax vs the estate transfer tax

Two completely different taxes touch a decedent's estate:

Form 1041 (income tax): taxes income EARNED BY the estate during administration (interest, dividends, rents on estate assets).
Form 706 (estate/transfer tax): a one-time tax on the FAIR VALUE of assets transferred at death, with the unified credit and applicable exclusion amount.

DNI does double duty: The same DNI figure caps the entity's distribution DEDUCTION and the beneficiary's INCLUSION, and it dictates the character (interest, dividend, tax-exempt) that flows out. If distributions exceed DNI, the excess is not deductible by the entity and not taxable to the beneficiaries (it is treated as a tax-free distribution of corpus).