25.1 C Corporation, S Corporation, and Partnership Comparison
Key Takeaways
- A C corporation is a separate taxpayer (Form 1120), so operating income taxed at the flat 21% rate and later dividends create two layers of federal tax.
- An S corporation (Form 1120-S) is a pass-through, but shareholder basis excludes entity-level bank debt even when the shareholder guarantees it.
- A partnership (Form 1065) is a pass-through with flexible allocations, separate inside and outside basis, and liability allocations that change partner basis.
- State-law legal form and federal tax classification are different layers: an LLC may be disregarded, a partnership, or elect to be a corporation under the check-the-box rules.
- On REG (72 MCQs + 8 task-based simulations, 4 hours, scaled 75 to pass), entity comparison is a recurring Area D topic worth roughly 12%-22% of the blueprint.
Why Entity Choice Matters on REG
Entity taxation sits in Area D of the REG blueprint (federal taxation of entities), historically 12%-22% of the section. The Regulation exam delivers 72 multiple-choice questions and 8 task-based simulations (TBSs) across a four-hour window, with a 15-minute optional break after the third testlet; you need a scaled score of 75 (on a 0-99 scale) to pass. Entity comparison threads through both the MCQ testlets and the simulations, so a clean mental model pays off repeatedly.
A CPA question often hides the answer in the entity label. Do not stop at legal form. A limited liability company (LLC) may be disregarded, taxed as a partnership, or elect corporate status under the check-the-box regulations (Reg. 301.7701-3). A corporation is a C corporation by default and is an S corporation only after a valid Form 2553 election with all eligibility tests met.
Core Comparison
| Feature | C Corporation | S Corporation | Partnership |
|---|---|---|---|
| Federal taxpayer | Entity pays 21% flat tax | Pass-through | Pass-through |
| Main return | Form 1120 | Form 1120-S | Form 1065 |
| Owner reporting | Dividends, sale gain, W-2 wages if employee | Schedule K-1, W-2 wages for services, distributions | Schedule K-1, guaranteed payments, distributions |
| Owner basis focus | Stock basis for sale or return of capital | Stock basis plus direct shareholder loans | Outside basis, including share of liabilities |
| Debt effect on owner basis | No basis from corporate debt | No basis from corporate debt (guarantee insufficient) | Liabilities generally increase partner basis (Sec. 752) |
| Allocations | Dividends pro rata by share | One class of stock blocks special allocations | Flexible if substantial economic effect met |
| Self-employment / payroll | Wages subject to FICA | Reasonable comp = FICA; distributions not SE | General partner share is SE income |
Notice the rows REG examiners exploit: the debt-to-basis row and the self-employment row produce the most distractors.
The Tax Personality of Each Entity
C corporation. Treat it as a separate taxpaying person. It recognizes income and deductions on Form 1120 at the flat 21% corporate rate (post-2017 TCJA). Cash to shareholders is a dividend to the extent of earnings and profits (E&P), then return of stock basis, then capital gain. This is the classic double tax: one tax at 21% inside, a second at the shareholder's qualified-dividend rate (0/15/20%) outside.
S corporation. Corporate legal shell, pass-through tax. Eligibility is strict: 100-shareholder limit, only U.S. individuals/estates/certain trusts (no partnerships or C-corp shareholders), one class of stock, and a domestic corporation. A shareholder-employee must take reasonable compensation (W-2) before extra cash is a distribution. The classic trap: stock basis rises with income and falls with distributions and losses, but a guaranteed bank loan to the corporation does not create basis.
Partnership. The most flexible. Partners can split profits, losses, and cash differently from capital, provided the allocation has substantial economic effect (Sec. 704(b)) or follows the partners' interests. A partner tracks outside basis; the partnership tracks inside basis. Under Sec. 752, a partner's share of liabilities is a deemed cash contribution (increase) or distribution (decrease).
CPA Exam Workflow and High-Yield Distinctions
- Identify the federal tax classification, not just the state-law label.
- Ask whether the entity or the owner pays the first layer of federal tax.
- Determine whether the owner receives wages, guaranteed payments, dividends, or K-1 pass-through items.
- Compute owner basis before testing distributions or losses.
- Watch planning triggers: reasonable comp, self-employment tax, QBI (Sec. 199A 20% deduction), exit strategy, built-in gain.
Quick distinctions examiners love:
- C-corp owners cannot deduct entity losses on the 1040; the loss is trapped inside.
- S-corp shareholders deduct losses only within basis, then at-risk, then passive limits.
- Partners get basis from partnership debt; economic risk of loss decides recourse vs. nonrecourse allocation.
- S status terminates if an ineligible shareholder is admitted or a second class of stock is created.
- Guaranteed payments are deductible by the partnership and ordinary income to the partner regardless of partnership profitability.
Takeaway: build the answer from the classification outward. The same fact pattern yields 21% corporate tax plus dividend, S-corp K-1 with stock-basis limits, or partnership treatment with Sec. 752 liability allocations.
A Worked Side-by-Side
Suppose a business earns 200,000 of operating income and the owners want all of it in cash. Trace each regime.
As a C corporation: the entity pays 21% = 42,000, leaving 158,000. If that 158,000 is paid as a qualified dividend taxed at 15%, the shareholder pays 23,700. Total federal tax is about 65,700, roughly a 32.85% combined effective rate. This is the double tax in numbers, and it is why closely held service businesses rarely choose C status.
As an S corporation: there is no entity tax. Assume the owner takes 80,000 of reasonable compensation (W-2, subject to FICA) and the remaining 120,000 flows through on the K-1 as ordinary income not subject to self-employment tax. The shareholder may also claim the Sec. 199A qualified business income (QBI) 20% deduction on the pass-through share if eligible. The FICA savings on the 120,000 distribution portion is the headline S-corp planning point - and the reasonable-compensation requirement is the IRS guardrail examiners love to test.
As a partnership (or LLC taxed as one): the full 200,000 flows through. A general partner's distributive share of trade-or-business income is self-employment income subject to SE tax; guaranteed payments for services are also SE income and ordinary to the partner but deductible to the partnership. QBI may again apply. There is no reasonable-comp concept, but the SE tax on the active share is the trade-off versus the S corporation.
The exam lesson: identical economics, three different federal tax bills. A REG MCQ that asks for the "total federal tax" or "amount subject to self-employment tax" is really asking you to pick the right regime and apply its single distinguishing rule - double tax, reasonable comp, or SE income on the active share.
A profitable domestic business wants limited liability, pass-through taxation, and the ability to allocate profits and losses differently from ownership percentages when the allocations have substantial economic effect. Which federal tax classification best fits these goals?
Which statement correctly describes how entity-level debt affects owner basis?