A two-shareholder S corporation owner pays himself a $20,000 salary and takes $180,000 in distributions, classifies his cousin who works 40 hours a week as a 1099 contractor, deducts the family SUV at 100% business use without a mileage log, and pays the home mortgage from the business checking account. Every one of those choices is a high-frequency exam trap, and each one has a defined cure.
The five federal classifications produce different combinations of liability protection, tax cost, and administrative burden.
Sole proprietorship benefits. No separate filing, no state organizational fee, easy startup. Detriments. Unlimited personal liability, full SE tax on net profit, no medical reimbursement plan unless spouse is employee.
Partnership benefits. Pass-through, flexible allocations under §704(b), basis from recourse and qualified nonrecourse debt. Detriments. General partners pay SE tax on distributive share plus guaranteed payments; technical termination rules require K-1 to every partner by March 15.
S corporation benefits. Avoid SE tax on profits above reasonable compensation, simple ownership structure, single layer of tax. Detriments.
Common mistakes
- Treating an LLC as a federal entity type. LLC is a state designation. Federal classification depends on members and elections. A single-member LLC files Schedule C by default unless Form 8832 or 2553 is filed.
- Assuming §179 can create a loss. §179 is capped at taxable income from any active trade or business. Excess carries forward. Bonus depreciation under §168(k) (100% for property acquired after January 19, 2025) is NOT income-limited.
- Missing the $10,000 Form 8300 trigger. "Cash" includes cashier's checks and money orders ≤$10,000 in designated transactions, not just currency. Filing window is 15 days of receipt; written notice to payor by January 31 of following year.
Bottom line
- Entity choice drives liability, SE tax, and audit risk: sole prop and partnership pay full 15.3% SE tax on profit; S corp owners owe payroll tax only on reasonable compensation; C corps pay flat 21% but face double taxation
- Worker classification uses common-law control test (behavioral, financial, relationship); misclassification triggers Form SS-8 review and §3509 reduced-rate penalties (1.5% of wages plus 20% of employee FICA if 1099s issued, double if not)
- 1099-NEC at $600 to nonemployees; Form 8300 within 15 days for cash receipts above $10,000 (recipient statement by January 31); payroll deposits semi-weekly or monthly based on $50,000 lookback; FUTA deposit when liability exceeds $500
- Depreciation hierarchy: §179 expense up to $2,500,000 (phase-out at $4,000,000, SUVs over 6,000 lbs capped at $31,300) → 100% bonus for property acquired after January 19, 2025 (40% only for property acquired before January 20, 2025) → MACRS; §179 limited...
Exam shortcut
Entity tax decision. Service business owner taking >$150K profit: think S corp first. Capital-reinvestment business: think C corp at 21%. Real estate with debt: partnership/LLC for basis from recourse debt and §469 grouping. Hobby vs business turns on §1.183-2(b) nine factors. Payroll deposit schedule. Lookback >$50,000 = semi-weekly, otherwise monthly. $100,000 next-day rule. $500 FUTA carry-forward threshold. $2,500 quarterly 941 exception. ACA penalty quick check.
The full lesson (about 5,733 words, 38 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 5
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