Taxation and Regulation (REG) CPA Exam Study Guide

Federal Taxation of Individuals

Individual Income Tax Formula

$$ \begin{aligned} &\text{Gross Income} \\ - \; &\underline{\text{Adjustments ("Above the line" deductions)}} \\ = \; &\text{Adjusted Gross Income (AGI)} \\ - \; &\underline{\text{Greater of Standard or Itemized Deductions}} \\ = \; &\text{Taxable Income before QBI Deduction} \\ - \; &\underline{\text{QBI Deduction}} \\ = \; &\text{Taxable Income} \\ \times \; &\underline{\text{Federal Income Tax Rate}} \\ &\text{Federal Income Tax} \\ - \; &\text{Tax Credits} \\ + \; &\text{Other Taxes (e.g., Self-Employment Tax)} \\ - \; &\underline{\text{Payments (Withholding, Estimated Taxes)}} \\ = \; &\textbf{Tax Due or Refund} \end{aligned} $$

New Exam Assumption (2026): References to individual wages or compensation do not include overtime or tips unless otherwise stated. Under the One Big Beautiful Bill Act, up to $25,000 of tips may be deducted per year. Up to $12,500 of qualified overtime pay may be deducted for single filers, while married couples filing jointly can deduct up to $25,000.

Filing Requirements & Status

Who Must File & When

General Rule: A return is required if gross income meets or exceeds the standard deduction (including age/blindness additions).
Self-Employed: A return is required if net earnings from self-employment are $400 or more.
Deadline: April 15th.
Extensions: A 6-month extension to file (not to pay) is available via Form 4868.

Filing Status Rules

Status	Marital Requirement	Key Conditions / Dependents
Single	Unmarried or legally separated at year-end.	None.
Joint Returns (MFJ)	Married at year-end, common law, or spouse died during the year.	Cannot be filed if divorced during the year.
Married Filing Separately	Married.	Separate property states report own income. Community property states split most income 50/50.
Qualifying Widower	Unmarried (spouse died in the prior two years).	Must maintain a home for a dependent child (biological/adopted) for the WHOLE year and provide > 50% of home costs.
Head of Household (HoH)	Unmarried (or lived apart from spouse for the last 6 months).	Must maintain a home for a qualifying person for MORE THAN HALF the year. (Dependent parents do not need to live with the taxpayer).

Qualifying Dependents (Child vs. Relative)

Test Category	Qualifying Child (QC)	Qualifying Relative (QR)
Relationship	Child, stepchild, sibling, or descendant of any of these.	Related to taxpayer in specified ways OR lived with taxpayer for the entire year.
Age	Under 19, or under 24 (full-time student), or permanently disabled.	No age limit.
Residency	Lived with taxpayer for more than 50% of the year.	No requirement if related; otherwise, must live in household for entire year.
Support	Child must NOT have provided > 50% of their own support.	Taxpayer MUST provide > 50% of the relative's total support.
Gross Income	No specific gross income test.	Relative's gross income must be less than the Exemption Amount ($5,300 for 2026).

Special Dependency Allocation Rules

Scenario	Statutory Rule & Form	Operational Requirements
Children of Divorced / Separated Parents	Custodial Parent Presumption (Form 8332)	• The parent with physical custody for the greater part of the year is entitled to the dependency claim. • The noncustodial parent may claim the exemption only if the custodial parent signs Form 8332 (Release/Revocation of Release of Claim to Exemption). • Equal Custody Tie-Breaker: If parents have custody for an equal number of nights, the exemption is awarded to the parent with the higher AGI.
Multiple Support Agreements	Group Support Allocation (Form 2120)	• Applied when two or more individuals collectively provide > 50% of an individual's support, but no single taxpayer provides > 50%. • The claiming taxpayer must provide more than 10% of the individual's total support. • All other qualifying contributors providing > 10% must sign Form 2120 waiving their right to claim the dependent in that tax year.

Gross Income: Concepts & Accounting

Realization: The economic event that triggers income (e.g., a sale).
Recognition: Recording the income on the tax return.

Accounting Method

Cash Method: Recognition occurs when revenue is actually or constructively received.
Accrual Method: Recognition occurs when revenue is earned.

Gross Income: Taxable Items

Income Category	Recognition Rule
Salaries and Wages	Money, property (at FMV), and bargain purchases from an employer.
Guaranteed Payments	Taxable ordinary income to the receiving partner.
Taxable Fringe Benefits	FMV included unless specifically excluded. Life insurance premiums > $50,000 coverage and employer Roth 401(k) contributions are taxable.
State/Local Tax Refunds	Taxable only if the taxpayer itemized deductions in the prior year (tax benefit rule).
Gambling Winnings	Fully included. Losses are an itemized deduction strictly limited to the extent of winnings.
Prizes and Awards	FMV is taxable unless assigned directly to a charity without taking possession.
Cancellation of Debt	Generally taxable income, subject to insolvency/bankruptcy exceptions.
K-1 Flow-Through Income	Ordinary business income and separately stated items from Partnerships, S-Corps, Estates, and Trusts.
Unemployment Compensation	100% fully taxable at the federal level.
Pension and Annuity Income	Taxable to the extent distributions exceed the unrecovered after-tax basis (Exclusion Ratio).

Tax Benefit Rule: State & Local Tax (SALT) Refund Formula

A state or local income tax refund received is includible in current-year gross income only if the prior-year payment produced an actual federal tax benefit. The taxable amount is calculated as:

$$\text{Taxable Refund} = \min \left\{ \text{Actual Refund Received},\; (\text{Prior Itemized Deductions} - \text{Prior Standard Deduction}),\; \text{Prior Allowable SALT Claimed} \right\}$$

Standard Deduction Claimed in Prior Year: Refund is $0 taxable (100% tax-free).
Itemized in Prior Year but Subject to Statutory SALT Cap: If total SALT paid was $14,000 and $10,000 was deducted, a $1,000 refund does not reduce the $10,000 deduction (since actual tax paid was still ≥ $10,000), resulting in $0 taxable refund.

Gross Income: Investment & Other Income

Interest Income

Treatment	Source / Instrument	Key Rules (2026)
Taxable	Corporate Bonds, Bank Accounts, Seller-Financed Mortgages	Fully taxable at the federal level. (Amortization of a bond discount is also taxable).
Taxable	U.S. Treasury Bonds	Taxable at the federal level, but exempt from state/local income taxes.
Tax-Exempt	State & Local Government (Municipal) Bonds	Generally exempt from federal income tax.
Tax-Exempt	U.S. Series EE Savings Bonds	Excluded if used for qualified higher education. (Subject to AGI phase-out: $101,800 - $116,800 S / $152,650 - $182,650 MFJ).

Dividend Distribution "Waterfall"

The tax treatment of a corporate distribution flows through three sequential buckets:

Qualified dividends meeting specific source and holding period requirements are taxed at lower long-term capital gains rates.

Annuity Exclusion Ratio & Post-Actuarial Adjustments

$$\text{Excludable Portion Per Monthly Payment} = \frac{\text{Net Tax Basis (Investment in Contract)}}{\text{Total Expected Months (IRS Actuarial Life Table)}}$$

Actuarial Outcome	Tax Treatment of Remaining Payments / Unrecovered Basis
Annuitant Outlives Life Expectancy	Once cumulative exclusions equal total initial basis, the exclusion ratio terminates. 100% of all subsequent payments received are fully taxable as ordinary income.
Annuitant Dies Prior to Full Recovery	The remaining unrecovered basis is deducted as an itemized deduction on the decedent's final Form 1040. This deduction is exempt from the 7.5% AGI medical floor.

Social Security Income

Taxability depends on the taxpayer's Provisional Income.

$$\text{Provisional Income} = \text{AGI} + \text{Tax-Exempt Int.} + (50\% \times \text{SS Benefits})$$

Income Tier	Taxability	Provisional Income Thresholds (2026)
Low Income	0% Taxable	Below $25,000 (Single) / $32,000 (MFJ)
Middle Income	Up to 50% Taxable	Between Low and Upper thresholds
Upper Income	Up to 85% Taxable	Above $34,000 (Single) / $44,000 (MFJ)

Net Investment Income Tax (NIIT)

A 3.8% tax applies to the lesser of net investment income or the excess of modified AGI over a threshold ($250,000 for MFJ, $200,000 for Single/HoH).

Gross Income: Nontaxable & Partially Taxable Items

Item Category	Tax Treatment & Limitations (2026)
Life Insurance Proceeds	Generally fully excluded from the beneficiary's gross income.
Gifts & Inheritances	Nontaxable to the recipient.
Physical Injury Awards	Personal physical injury or illness awards, workers' compensation, and Medicare are excluded.
Accident Insurance	Excluded only if the taxpayer paid the premiums.
Foreign-Earned Income	Up to $132,900 can be excluded if strict residency tests are met.
Scholarships (Degree)	Excludable for tuition and fees. Amounts used for room and board are fully taxable.
Scholarships (Non-Degree)	Fully taxable at fair market value.
Tuition Reductions (Grad)	Taxable if it represents their only compensation; nontaxable if provided in addition to other taxable compensation.

Schedule C Details & SE Tax

Business Interest Expense Limitation

For businesses with average gross receipts over $32 million, the business interest expense deduction is limited to the sum of:

Business interest income
30% of the adjusted taxable income
Floor plan financing interest

Common Nondeductible Sch. C Expenses

Salaries paid to the sole proprietor (these are considered a draw/withdrawal)
Federal income tax
Bad debt expense for a cash-basis taxpayer
Personal portion of auto, travel, and meal expenses
Charitable contributions (these are an itemized deduction on Schedule A)

Self-Employment Tax Calculation

Net Earnings from Self-Employment

$$\text{Net Earnings from SE} = \text{Business Income} \times 92.35\%$$

Self-Employment Tax

$$\text{Self-Employment Tax} = \text{Net Earnings from SE} \times 15.3\%$$

Nontaxable Fringe Benefits

Benefit Type	Tax Treatment & 2026 Limits
Health Insurance	Employer-paid premiums are excludable. Payouts are includable unless reimbursing medical expenses or permanent bodily loss.
Educational Expenses	Up to $5,250 excluded (applies to tuition or qualified student loan payments).
Adoption Assistance	Up to $17,670 excluded (phases out for MAGI between $265,080 - $305,080).
Dependent Care	Up to $7,500 excluded ($3,750 if married filing separately).
Transit & Parking	Up to $340 per month for each category excluded.
Flexible Spending (FSA)	Up to $3,400 in pre-tax contributions. Subject to "use-it-or-lose-it", unless the plan adopts an optional 2.5-month grace period or up to a $680 carryover.
De Minimis / Meals	Too small to account for (De Minimis) and meals/lodging provided for the convenience of the employer are excluded.

Employee Discounts & Group-Term Life Insurance Rules

Benefit Program	Statutory Exclusion Limit	Tax Treatment of Excess Benefit
Employee Discount on Merchandise	Exclusion capped at the employer's Gross Profit Percentage: Gross Profit % = (Sales − COGS) ÷ Sales	Discount provided in excess of gross profit percentage is taxable compensation on Form W-2.
Employee Discount on Services	Exclusion capped at 20% of the normal price charged to non-employee customers.	Discount exceeding 20% is taxable compensation on Form W-2.
Group-Term Life Insurance ($50,000 Cap)	Premiums paid by employer for up to $50,000 face coverage are 100% tax-free.	Premiums for coverage in excess of $50,000 are taxable wages calculated via IRS Table I uniform rates.

Rental & Hobby Income/Loss

Rental Income (Schedule E)

Property Use Category	Tax Treatment
Rented < 15 Days	Treated as a personal residence. Rental income is excluded from gross income. Deduct mortgage interest and real estate taxes fully on Schedule A.
Rented 15+ Days & Used as Residence (Personal use > 14 days or 10% of rental days)	Prorate expenses between personal and rental use based on days used. Rental deductions are strictly limited to rental income (no net rental loss allowed; excess carried forward). Deduct the personal portion of mortgage interest/taxes on Schedule A.
Rented 15+ Days (Non-Residence)	Treat as a full rental property (no allocation needed). Losses are possible but subject to passive activity, at-risk, and other rules.

Passive Activity Loss: $25,000 Active Participation Rental Exception

Although passive activity losses generally cannot offset active wages or portfolio income, an individual taxpayer who actively participates in rental real estate can deduct up to $25,000 of net passive rental losses against non-passive income annually.

$$\text{Allowable Deduction} = \$25,000 - \left[ (\text{AGI Before Passive Loss} - \$100,000) \times 50\% \right]$$

Taxpayer Modified AGI	Phaseout Reduction	Allowable Loss Deduction Against Active Income
≤ $100,000	$0 Reduction	Full $25,000 Maximum Deduction
$100,001 to $149,999	50¢ per $1.00 of AGI over $100,000	Partial Deduction (e.g., at $120,000 AGI → $15,000 allowed)
≥ $150,000	100% Phased Out	$0 Active Offset (Losses carry forward indefinitely under IRC §469(b))

Participation Standards Comparison: Active vs. Material

Standard	Statutory Qualification Criteria	Tax Classification & Loss Treatment
Active Participation	Requires maintaining at least a 10% ownership interest AND participating in bona fide management decisions (approving tenants, setting rental terms, approving repairs).	Allows up to $25,000 passive rental real estate loss offset against non-passive income (phased out 50¢ per $1 of AGI between $100,000 and $150,000).
Material Participation	Requires meeting one of the IRS tests (primarily 500+ hours of participation during the tax year under IRC §469).	Reclassifies the entire activity as non-passive (losses are fully deductible against ordinary income without passive loss caps).

Hobby Losses

If an activity is not engaged in for profit, expenses are not deductible. Income is still included in gross income. The IRS uses a nine-factor test to determine if an activity is a business (for profit) or a hobby:

Carrying on the activity in a businesslike manner.
The expertise of the taxpayer or their advisors.
The time and effort expended by the taxpayer.
Expectation that assets used in the activity may appreciate in value.
The success of the taxpayer in carrying on other similar or dissimilar activities.
The activity's history of income or losses.
The amount of occasional profits, if any.
The financial status of the taxpayer.
Elements of personal pleasure or recreation.

Taxation of Retirement Plan Distributions

The taxability of IRA distributions depends on the type of IRA and whether contributions were deductible.

Type of IRA	Principal	Earnings
Traditional Deductible	Taxable	Taxable
Traditional Nondeductible	Nontaxable	Taxable
Qualified Roth	Nontaxable	Nontaxable
Non-Qualified Roth	Nontaxable	Taxable

Distributions before age 59½ generally incur a 10% penalty, but exceptions exist for death, disability, medical expenses, first-time home purchase (up to $10k), education, and birth/adoption ($5k).

Tax Treatment of Divorce-Related Payments

Payment Type	Agreements Executed On or Before Dec 31, 2018	Agreements Executed After Dec 31, 2018
Alimony	Taxable income to recipient. Above-the-line deduction for payor.	Not taxable to recipient. Not deductible by payor.
Child Support	Not taxable to recipient; Not deductible by payor.
Property Settlements	Not a taxable event (carryover basis applies to the property).

Note: Payments are treated as child support first if the payment amount is scheduled to be reduced based on a child-related contingency (e.g., child turning 18).

Adjustments for AGI ("Above the Line")

Adjustment	2026 Rule / Limitation
Educator Expenses	Up to $350 for eligible pre-K through 12th-grade educators.
Health Savings Account (HSA)	Pre-tax contributions up to $4,400 (Self) / $8,750 (Family); add $1,000 if age 55+.
Self-Employment Tax	50% of SE taxes paid is deductible.
Self-Employed Health Insurance	100% of premiums are deductible.
Self-Employed Retirement	Contributions to SEP, SIMPLE, or Solo 401(k).
Alimony Paid	Only for divorce agreements executed on or before Dec 31, 2018.
Early Withdrawal Penalty	Penalty on early withdrawal of savings is fully deductible.
Auto Loan Interest (U.S.)	Up to $10,000 for personal-use, NEW U.S.-assembled vehicles (subject to MAGI phase-out).
Student Loan Interest	Up to $2,500 maximum per year (subject to MAGI phase-outs).
IRA Contributions (Traditional)	Up to $7,500 (or $8,600 if age 50+). Phased out if an active participant in an employer plan.
Moving Expenses	Strictly restricted to active-duty Armed Forces members moving pursuant to military orders.
Charitable Contributions (OBBBA)	Starting in the 2026 tax year under the "One Big Beautiful Bill" legislation, non-itemizers taking the standard deduction can claim an above-the-line deduction of up to $1,000 for single filers ($2,000 for married filing jointly) for qualifying cash donations.

Self-Employed Retirement Plan Deduction Formulas

The deduction base is Net Self-Employment Income (Schedule C Net Profit − 50% SE Tax):

Plan Type	Maximum Statutory Contribution / Deduction Formula
SEP IRA	Lesser of: Annual Statutory Cap, OR 20% × (Schedule C Net Profit − 50% SE Tax)
SIMPLE IRA	Lesser of: Indexed Statutory Cap (+ catch-up if eligible), OR 100% × Net SE Earnings
Solo 401(k)	Lesser of: Annual Statutory Cap, OR (20% × Net SE Earnings) + Elective Deferrals

Itemized Deductions (Schedule A)

Deduction	Limitation / Rule
Medical Expenses	Deductible to the extent qualified expenses exceed 7.5% of AGI.
State & Local Taxes (SALT)	Limited to $40,400 (if income < $505,000); phases down 30¢ per $1 over limit to a hard $10,000 floor.
Home Mortgage Interest	Deductible on up to $750,000 of indebtedness (primary and secondary home).
Investment Interest	Limited to net taxable investment income.
Charitable Contributions	Subject to a 0.5% AGI deduction floor (OBBBA 2026) and statutory percentage of AGI ceilings depending on property type and donee organization. 5-year carryforward.
Casualty Losses	Federally declared disasters only. Loss minus $100 per event, minus 10% of AGI.
Gambling Losses	Deductible only to the extent of recognized gambling winnings.

High-Income Itemized Deduction Limitation: Total itemized deductions face a 2/37 benefit reduction formula for high-income earners rather than a standard AGI phase-out.

Charitable Contribution Valuation & AGI Limitation Framework

Type of Donated Property	Valuation Standard (Deduction Base)	Public Charities (501(c)(3)) Limit	Private Non-Operating Foundations Limit
Cash / Currency	Actual Cash Contributed	60% of AGI	30% of AGI
Ordinary Income Property / Short-Term Assets (Held ≤ 1 Year)	Lesser of Adjusted Cost Basis OR Current FMV (Eliminates ordinary profit)	50% of AGI	30% of AGI (Cost Basis)
Long-Term Capital Gain Property (Held > 1 Year)	Fair Market Value (FMV) (Full appreciation deducted; $0 gain recognized)	30% of AGI	20% of AGI (Cost Basis)
Tangible Personal Property (Unrelated Use by Charity)	Adjusted Cost Basis (Reduced by unrealized LTCG)	50% of AGI	20% of AGI

OBBBA 0.5% AGI Floor (2026): Starting in the 2026 tax year under the One Big Beautiful Bill Act (OBBBA), itemizers face a new 0.5% Adjusted Gross Income (AGI) deduction floor on charitable contributions (only donations exceeding 0.5% of AGI are deductible).
Carryforward: Disallowed excess contributions carry forward for 5 taxable years (FIFO ordering applies; current-year contributions used first).
Services Donated: Value of professional services or personal time is $0 deductible. Unreimbursed out-of-pocket expenses (including statutory volunteer auto rate) are deductible.

Standard & Additional Deductions

Taxpayers can take the greater of their standard deduction or itemized deductions.

2026 Baseline Standard Deductions

Filing Status	Base Deduction Amount
Single / Married Filing Separately	$16,100
Head of Household	$24,150
Married Filing Jointly / Surviving Spouse	$32,200

Additional Standard Deduction & Senior Relief

An additional deduction is available for taxpayers who are age 65 or older and/or blind.

Unmarried: $2,050 for each condition (age or blindness).
Married: $1,650 for each condition, per taxpayer.

OBBBA Senior Deduction (2026)

Benefit: Taxpayers age 65 and older can take a separate $6,000 bonus deduction per qualifying individual (up to $12,000 if both spouses are 65+). This can be taken whether they itemize or use the standard deduction.
Phase-out (Single/HoH): The deduction begins to phase out for taxpayers with a Modified Adjusted Gross Income (MAGI) over $75,000.
Phase-out (MFJ): The deduction begins to phase out for couples filing jointly with a MAGI over $150,000.
Non-Itemizer Charitable Deduction: Standard deduction filers can also take an above-the-line deduction of up to $1,000 ($2,000 MFJ) for qualifying cash donations.

Casualty Loss Calculation

Personal casualty losses are deductible only if they occur in a federally declared disaster area. The calculation is as follows:

Determine Loss Amount: Take the lesser of the property's lost cost (adjusted basis) or its decreased FMV.
Subtract Insurance: Reduce the loss amount by any insurance reimbursement received.
Apply $100 Floor: Subtract $100 from the loss for each separate casualty event.
Apply 10% AGI Floor: Subtract 10% of Adjusted Gross Income (AGI) from the remaining loss.

$$ \begin{aligned} &\text{Lesser of Adjusted Basis or Decrease in FMV} \\ - \; &\underline{\text{Insurance Reimbursement}} \\ = \; &\text{Loss Amount} \\ - \; &\underline{\$100 \text{ per casualty event}} \\ = \; &\text{Eligible Loss} \\ - \; &\underline{10\% \times \text{AGI}} \\ = \; &\textbf{Deductible Casualty Loss (Schedule A)} \end{aligned} $$

QBI Deduction (Section 199A)

A deduction of up to 20% of Qualified Business Income from flow-through entities.

QTB: Qualified Trade or Business (Standard businesses).
SSTB: Specified Service Trade or Business (Health, law, accounting, consulting, athletics, financial services).

New in 2026 (OBBBA)

A new $400 minimum QBI deduction applies to active business owners who materially participate and have at least $1,000 of QBI, regardless of income limitations that might otherwise eliminate their deduction.

Deductibility Thresholds

graph TD Income["Taxpayer's Taxable Income"] --> Below["Below Threshold
($201,750 S / $403,500 MFJ)"] Income --> Between["Between Thresholds"] Income --> Above["Above Threshold
($276,750 S / $553,500 MFJ)"] Below --> Full["Full 20% Deduction
for both QTB & SSTB"] Between --> PhaseQTB["QTB: W-2 & Property Limits Phase In"] Between --> PhaseSSTB["SSTB: Base Deduction Phases Out"] Above --> LimitQTB["QTB: Subject to strict W-2 / Property Limits"] Above --> NoSSTB["SSTB: No Deduction Allowed"]

Section 199A Statutory Limitation Mechanics & Formulas

Taxable Income Tier	Qualified Trade or Business (QTB)	Specified Service Trade or Business (SSTB)
Below Lower Statutory Threshold	Full 20% Deduction: 20% × QBI (No W-2 wage or UBIA limits apply).	Full 20% Deduction: 20% × QBI (No W-2 wage or UBIA limits apply).
Phase-In Range (Within Statutory Phase-In Bracket)	W-2 wage and UBIA property limitations phase in pro-rata.	Applicable percentage of QBI, wages, and UBIA phases down to zero.
Above Upper Statutory Threshold	Deduction is the Lesser of: 1. 20% × QBI, OR 2. Greater of: • 50% × W-2 Wages, or • (25% × W-2 Wages) + (2.5% × UBIA Property)	$0 Deduction Allowed (100% excluded for health, law, accounting, consulting, performing arts, athletics, financial services).

$$\mathbf{\text{Overall Cap:}} \quad \text{Allowable Deduction} = \min \left[ \text{Tentative QBI Deduction}, \; 20\% \times (\text{Taxable Income} - \text{Net Capital Gains}) \right]$$

Tax Credits

Credits reduce tax liability dollar-for-dollar. Refundable credits can result in a refund if they exceed the tax owed; nonrefundable credits can only reduce liability to zero.

Credit Name	Type	Description & 2026 Limits
Child Tax Credit	Partially Refundable	Up to $2,200 per qualifying child. Refundable portion is the lesser of excess credit, (earned income - $2,500) * 15%, or $1,700 per child.
Earned Income Credit	Refundable	For low-to-moderate-income working individuals who live in the U.S. for more than half the year.
Child and Dependent Care	Nonrefundable	Ranges from 20% to 50% of expenses (based on AGI). Max $3,000 for one qualifying person, $6,000 for two or more.
American Opportunity (AOTC)	Partially Refundable	Max $2,500 per student (first 4 years of college). 40% of the credit is refundable.
Lifetime Learning (LLC)	Nonrefundable	Max $2,000 per taxpayer (unlimited years of education).
Adoption Credit	Partially Refundable	For qualified adoption expenses up to $17,670. Up to $5,120 is refundable, excess carries forward up to 5 years.
Foreign Tax Credit	Nonrefundable	Lesser of foreign taxes paid or the U.S. tax liability on foreign income.

Advanced Credit Computational Formulas

Credit Program	Statutory Formula & Limitation Base	Carryover & Refundability
General Business Credit (GBC)	100% of First $25,000 Net Regular Tax + 75% × (Net Regular Tax − $25,000)	Nonrefundable. Carryback 1 Year; Carryforward 20 Years.
Credit for Elderly / Disabled	15% × [Base ($5,000 S / $7,500 MFJ) − Nontaxable SS − 50% × (AGI − Phaseout Threshold)]	Nonrefundable. No carryover allowed.
Work Opportunity Tax Credit (WOTC)	40% of first-year qualified wages paid to targeted groups up to $6,000 ($2,400 max credit); 40% of first-year wages up to $3,000 ($1,200 max credit) for summer youth.	Component of GBC (1-yr carryback, 20-yr carryforward).

Kiddie Tax

The net unearned income of a dependent child is taxed at the parents' marginal rate.

2026 Thresholds:

First $1,350: Tax-free (Limited Standard Deduction)
Next $1,350: Taxed at Child's Rate
Over $2,700: Taxed at Parents' Marginal Rate

$$\text{Net Unearned Income} = \text{Total Unearned Income} - \$2,700 \text{ (2026)}$$

Estimated Taxes & Underpayment Penalty

Taxpayers must make estimated tax payments if they expect to owe at least $1,000 in tax and their withholding is insufficient.

Avoiding the Penalty

To avoid a penalty, withholding and timely estimated payments must equal or exceed the lesser of:

90% of the current year's tax liability, OR
100% of the prior year's tax liability (110% if prior year AGI > $150,000).

Trump Accounts

Category	Rules & Limitations
Contributions	• Private Cap: $5,000/year total (no earned income needed). • Family: After-tax (not deductible). • Employer: Up to $2,500 pre-tax. • Gov Seed: $1,000 for births (2025–2028). Does not count toward cap.
Investments	Restricted strictly to broad U.S. equity index funds.
Taxation & Distributions	• Lock-up: Locked until age 18, then functions as a Traditional IRA. • Pro-Rata Tax: Family funds come out tax-free (basis). Earnings, employer match, and the gov seed are taxed proportionally as ordinary income.
Penalties	• Early Withdrawal: 10% penalty on the taxable portion before age 59½. • Exceptions: Standard IRA exceptions (college, $10k homebuyer) remove the 10% penalty, but ordinary income tax still applies.

Property Taxation

Property Basis & Acquisition

Acquisition Method	Basis Rule & Holding Period
Purchased Property	Basis equals the cost plus capital improvements and any costs to place the asset into service. Ordinary repairs and maintenance are expensed.
Inherited Property	Basis is the Fair Market Value (FMV) at the date of death OR the alternate valuation date (earlier of 6 months after death or date of distribution). The holding period is always long-term.
Gifted Property	Generally, the donor's adjusted basis carries over (carryover basis). If the FMV at the date of the gift is lower than the donor's adjusted basis, dual basis rules apply depending on the future sales price.
Converted (Personal to Business)	Basis for Depreciation: Lesser of the property's adjusted basis or its FMV on the date of conversion. Basis for Gain/Loss: For gains, use adjusted basis. For losses, use the lesser of adjusted basis or FMV at conversion.
Stock Splits & Dividends	Generally nontaxable. The original basis is allocated over the new total number of shares (basis spreading).

Converted Property (Personal to Business Use) Dual Basis Mechanics

Purpose / Calculation	Statutory Basis Formula	Resulting Tax Consequence
Depreciation Basis	Lesser of: Adjusted Cost Basis OR FMV at Conversion	Prevents converting personal nondeductible losses into business depreciation deductions.
Subsequent Sale at a Gain	Gain Basis = Adjusted Cost Basis − Depreciation Allowed	Gain recognized = Sales Price − Gain Basis.
Subsequent Sale at a Loss	Loss Basis = Lesser of (Adjusted Cost Basis, Conversion FMV) − Depreciation	Loss recognized = Sales Price − Loss Basis.
Sales Price Between Gain & Loss Basis	Basis = Sales Price	$0 Gain Recognized; $0 Loss Recognized.

Installment Sales Method

Gross Profit Percentage

$$\text{Gross Profit \%} = \frac{\text{Selling Price} - \text{Adjusted Basis}}{\text{Total Contract Price}}$$

Recognized Gain in Year t

$$\mathbf{\text{Recognized Gain in Year } t} = \text{Cash Collected in Year } t \times \text{Gross Profit \%}$$

Mandatory Immediate Recapture Rule: All Section 1245 and Section 1250 depreciation recapture must be recognized as ordinary income in the year of sale, regardless of whether any cash is collected. Only the remaining economic gain is eligible for installment reporting.

Basis of Gifted Property

The general rule is that the donee's basis is the same as the donor's adjusted basis. However, an exception applies if the FMV at the date of the gift is lower than the donor's adjusted basis.

If Future Sales Price is...	Basis to Use	Result
Greater than Donor's Adjusted Basis	Donor's Adjusted Basis	Gain
Less than FMV at Gift Date	FMV at Gift Date	Loss
Between FMV and Donor's Adjusted Basis	Sales Price	No Gain or Loss

Holding Period & Depreciation Basis

Holding Period: If the donor's basis is used, the holding period tacks. If the FMV is used, the holding period starts at the date of the gift.
Depreciation Basis: The basis for depreciation is the lesser of the donor's adjusted basis or the FMV at the date of the gift.

Business Property Deductions & Amortization

Deduction Type	Rules & Limitations (2026)
De Minimis Safe Harbor	Allows immediate expensing of low-cost property. The limit is $5,000 per item if the taxpayer has an applicable financial statement (AFS), and $2,500 per item without an AFS.
Section 179 Deduction	Immediate expensing of qualifying business property. Maximum deduction is $2,560,000. Phased out dollar-for-dollar once property placed in service exceeds $4,090,000. Cannot create a net loss.
Bonus Depreciation	Reinstated by OBBBA at a permanent 100% rate for first-year expensing of eligible property. Applies to tangible property with a recovery period of 20 years or less and computer software. Applies to both new and used property.
Special Depreciation Ordering	Bonus depreciation is claimed after Section 179 expensing and before regular MACRS depreciation. Eligible property includes property with recovery period ≤ 20 years, water utility property, and qualified improvements.
Research & Experimental (R&E) Costs	Mandatory capitalization and amortization: amortized over 5 years (60 months) for domestic research and 15 years (180 months) for foreign research, using mid-year convention. Cannot be immediately expensed.
Organizational & Start-Up Costs	Immediate expense of the first $5,000 for each category (reduced dollar-for-dollar if costs exceed $50,000). Remaining costs are amortized over 180 months (15 years). Excludes costs of issuing equity.
Section 197 Intangibles	Purchased intangibles (goodwill, franchises, trademarks, customer lists) are amortized using the straight-line method over 180 months (15 years). (Note: Goodwill is tax-only; not amortized under GAAP).
Depletion	Cost Depletion is acceptable for GAAP and Tax. Percentage Depletion (a statutory percentage of gross income) is allowed for Tax only.

Like-Kind Exchanges (Real Property)

Nonrecognition of gain or loss is mandatory for qualifying exchanges of real property held for business or investment use. Personal property, inventory, stocks, and partnership interests do not qualify.

Computational Step	Statutory Calculation Formula
1. Realized Gain / Loss	Realized Gain = (FMV New Real Property + Boot Received) − (Adjusted Basis Old Property + Boot Paid)
2. Recognized Gain	Recognized Gain = Lesser of Realized Gain OR Net Boot Received (Note: Realized losses are NEVER recognized in like-kind exchanges).
3. Basis in Replacement Property (Subtractive)	New Basis = FMV of Replacement Real Property − Deferred Gain
4. Basis in Replacement Property (Additive)	New Basis = Adjusted Basis Given + Boot Paid + Recognized Gain − Boot Received

Critical Like-Kind Exchange Timelines

45-Day Identification Window: Replacement real property must be formally identified in writing within 45 calendar days of transferring the relinquished property.
180-Day Receipt Window: Replacement property must be received by the earlier of 180 calendar days after transfer or the due date of the tax return (including extensions).
Net Debt Relief: Debt assumed by the transferee minus debt assumed by the transferor constitutes boot received. Cash paid offsets net debt relief.

Involuntary Conversions & Principal Residence Sale

Involuntary Conversions

Gain Recognized

$$\text{Gain Recognized} = \min(\text{Realized Gain}, \; \text{Unreinvested Proceeds})$$

Basis in Replacement Property

$$\text{Basis in Replacement Property} = \text{Cost of Replacement Property} - \text{Deferred Nonrecognized Gain}$$

Conversion Event	Statutory Reinvestment Period	Standard for Replacement Property
Casualty / Theft / Destruction	2 Years from tax year-end of realization	"Similar or related in service or use" (Functional use test).
Condemnation of Business / Investment Real Property	3 Years from tax year-end of realization	Broad "Like-Kind" standard.

Principal Residence Gain Exclusion

Filing Status	Maximum Gain Exclusion	Statutory Eligibility Tests (2-out-of-5-Year Rule)
Single / HOH / MFS	$250,000	Taxpayer must have owned and occupied the home as principal residence for ≥ 2 years during the 5-year period ending on sale date.
Married Filing Jointly (MFJ)	$500,000	1. Either spouse meets the 2-year ownership test; AND 2. Both spouses meet the 2-year use test; AND 3. Neither spouse utilized the primary residence exclusion within the prior 2 years.

Depreciation (MACRS)

Personal Property

Class	Property Types
3-Year	Special tools, certain racehorses
5-Year	Cars, light trucks, computers, copiers
7-Year	Furniture, fixtures, machinery, equipment
10-Year	Boats, water transportation equipment
15-Year	Qualified improvements to interior of nonresidential buildings

Convention: Uses Half-Year convention by default. The Mid-Quarter convention is required if more than 40% of personal property is placed in service during the 4th quarter.

Real Property (Straight-Line)

Class	Property Types
20-Year	Farm buildings, municipal sewers
27.5 Years	Residential Rental Property
39 Years	Non-Residential (Business) Property

Convention: Always uses the Mid-Month convention. Land is never depreciated.

Advanced Depreciation Rules

Additional Section 179 Rules

Cannot be acquired from a related party.
Land and improvements to land do not qualify.
Not available for investment, rental, or most real property (qualified interior non-residential improvements are an exception).

Depreciation in Year of Disposal

Convention	Application Rule	Calculation Example
Half-Year	Take exactly one half-year of depreciation, regardless of the month sold.	Annual Depreciation × 50%
Mid-Quarter	Treat property as sold in the exact midpoint of the quarter it was disposed in.	Q1 Sale = Full Year Amount × 12.5% Q2 Sale = Full Year Amount × 37.5%
Mid-Month (Real Property)	Take depreciation for the number of full months owned + a half-month for the disposal month.	Sold in May (Month 5): (4.5 / 12) × Annual Amount

Depreciation Recapture: §1231, §1245, §1250, & §291

Code Section	Eligible Asset Class	Recapture Calculation & Tax Character
Section 1245 Recapture	Depreciable Personal Property (Equipment, Machinery, Autos, Fixtures)	Ordinary Income = Lesser of (1) Total Accumulated Depreciation, or (2) Total Realized Gain. Excess gain over depreciation is §1231 LTCG.
Section 291 Recapture	C Corporations Disposing of Real Property (Section 1250 Buildings)	Ordinary Income = 20% × Lesser of: (1) Straight-line depreciation claimed, or (2) Realized Gain. Remaining 80% is §1231 LTCG.
Unrecaptured §1250 Gain	Individual Taxpayers Disposing of Real Property	Gain attributable to straight-line depreciation is taxed at a Maximum 25% Rate. Excess gain is §1231 LTCG (taxed at 0/15/20%).

Section 1231 Netting Process & 5-Year Lookback Rule

Net §1231 Outcome	Tax Characterization & Lookback Mechanism
Net §1231 Loss	Treated as 100% Ordinary Loss (fully deductible against ordinary income without the $3,000 capital loss limitation).
Net §1231 Gain (5-Year Lookback)	Ordinary Income: Recaptured to the extent of unrecaptured net Section 1231 losses from the prior 5 tax years. Long-Term Capital Gain: Any remaining excess gain receives preferential LTCG rates.

Capital Gains & Losses

Feature	Individuals	C-Corporations
Net Loss Deduction	$3,000 max per year	$0 (No ordinary deduction)
Carryback	None	3 Years
Carryforward	Indefinite	5 Years

Statutory Non-Capital Assets

Excluded Category	Description & Tax Classification
Accounts / Notes Receivable	Generated from the sale of goods or performance of services in ordinary business (Ordinary Asset).
Copyrights & Creative Works	Held by the original creator who produced the property (Ordinary Asset). Purchased copyrights are depreciable §1231 assets.
Inventory	Goods held for sale to customers in the ordinary course of business (Ordinary Asset).
Depreciable / Real Business Property	Equipment, machinery, and real estate used in trade/business held > 1 year (Section 1231 Assets).

Related-Party Loss Disallowance & Right of Offset

Transaction Stage	Statutory Tax Consequence
Initial Sale to Related Party	Realized loss is 100% Disallowed. The purchasing related party takes a cost basis equal to the purchase price paid.
Resale to Unrelated Third Party	Right of Offset: The buyer's recognized gain on subsequent sale is reduced dollar-for-dollar by the seller's previously disallowed loss. Recognized Gain = Greater of [ $0, (Resale Price − Buyer Cost Basis) − Disallowed Loss ] (Note: The disallowed loss can only reduce future gain to $0; it can NEVER create or increase a recognized loss).

Special Rates & Cases

Unrecaptured Section 1250 Gain: Taxed at a maximum rate of 25% (applies to previously taken straight-line depreciation on real property).
Collectibles: Taxed at a maximum rate of 28%.
Worthless Stock: Treated as a capital loss as if sold on the last day of the tax year it becomes worthless.

Nondeductible Losses

Wash Sales: A loss is disallowed if an identical security is repurchased within 30 days before or after the sale. The disallowed loss is added to the basis of the new stock.
Related Party Transactions: Losses between related parties (e.g., siblings, >50% owned entities) are disallowed.

Entity Taxation

Corporate Formations & Basis Mechanics

Section 351 Requirements

Transfer of Property: Money, tangible real/personal property, and intangibles qualify. Services do NOT qualify (services trigger ordinary compensation income = FMV of stock received).
Solely in Exchange for Stock: Corporation issues equity shares (common or preferred).
80% Control Immediately After: The transferor group must own ≥ 80% of voting stock and ≥ 80% of non-voting stock immediately after the exchange.

Transaction Element	Shareholder Tax Impact	Corporation Tax Impact
Qualifying §351 Transfer (No Boot)	$0 Gain Recognized. Stock takes a carryover (substituted) basis.	$0 Gain Recognized. Assets take a carryover basis.
Transfer with Boot Received	Gain Recognized = Lesser of Realized Gain OR Boot Received.	$0 Gain Recognized. Asset basis increases by shareholder gain.
Liabilities in Excess of Basis	Gain Recognized = Total Liabilities Assumed − Total Basis of Property Transferred.	Asset basis stepped up by recognized gain from excess liabilities.

Basis Determination Formulas

Shareholder Stock Basis

$$ \begin{aligned} \text{Stock Basis} &= \text{Adjusted Basis of Property Transferred} \\ &+ \text{Cash Contributed} + \text{Gain Recognized} \\ &- \text{Boot Received} - \text{Liabilities Assumed by Corporation} \end{aligned} $$

Corporation Asset Basis

$$\text{Corporate Asset Basis} = \text{Shareholder Basis in Property} + \text{Gain Recognized by Shareholder}$$

C-Corporation: Filing & Estimated Taxes

Filing Requirements

C-Corps must file Form 1120 by the 15th day of the 4th month after their year-end. A 6-month extension is available.

Estimated Taxes

Corporations must pay estimated taxes in four quarterly installments.

Small Corps (< $1M TI): Required to pay the lesser of 100% of the current year's tax or 100% of the prior year's tax.
Large Corps (≥ $1M TI): Must pay 100% of the current year's tax (prior year safe harbor disallowed).

Corporate Accounting & Key Concepts

Accrual vs. Cash Method

The accrual method is required for:

Accounting for inventory (purchases and sales).
Tax shelters.
C-Corporations and partnerships with C-Corp partners with average annual gross receipts exceeding $32 million for the prior 3-year period.

Bonus Accruals (for Accrual-Basis Taxpayers)

Bonuses are deductible in the tax year they are accrued if they are paid out within 2.5 months of the taxpayer's year-end.

Bad Debts

Accrual Basis: Deductible only in the year the specific debt is written off (direct write-off method). The allowance method is not permitted for tax.
Cash Basis: Not deductible, as the income was never recognized.

C-Corporation: Book-to-Tax Reconciliation (Schedule M-1)

Reconciles book income (GAAP) with taxable income. Start with Net Income per books and adjust for differences.

Item	Book Treatment	Tax Treatment	M-1 Effect
Federal Income Tax Expense	Expense	Not Deductible	Add back
Municipal Bond Interest	Income	Not Taxable	Subtract
Life Insurance Premiums (Corp is beneficiary)	Expense	Not Deductible	Add back
Life Insurance Proceeds (Key Staff)	Income	Not Taxable	Subtract
Penalties & Fines	Expense	Not Deductible	Add back
Meals	100% Expense	50% Deductible	Add back 50%
Depreciation	Straight-Line	MACRS (Accelerated)	Subtract difference
Installment Sales	Income recognized at sale	Income recognized when cash is received	Subtract (until cash received)
Rent/Royalties in Advance	Income recognized when earned	Income recognized when received	Add back
Warranties Expense	Accrue estimated expense	Deduct only when paid	Add back difference

Corporate Distributions: Nonliquidating vs. Liquidating

Distribution Type	Corporation Entity Level Impact	Shareholder Tax Impact	Property Basis in Shareholder Hands
Nonliquidating Property Distribution	• Recognizes Gain: FMV − Basis. (If liability > FMV, FMV is deemed equal to liability). • LOSSES ARE DISALLOWED ($0).	Dividend Income = FMV of Property − Liabilities Assumed. (Subject to E&P waterfall rules).	Fair Market Value (FMV)
Complete Liquidation	• Recognizes GAIN AND LOSS: Treated as if the corporation sold all assets at FMV to the open market.	Capital Gain or Loss = FMV Received − Adjusted Stock Basis. (Fully taxable exchange).	Fair Market Value (FMV)

Parent-Subsidiary Liquidation (80% Exception)

If a parent corporation owns at least 80% of voting power and stock value of a subsidiary, liquidation of that subsidiary into the parent is completely tax-free. No gain/loss is recognized by the parent or sub, and the subsidiary's tax attributes (NOLs, basis, E&P) carry over to the parent.

C-Corporation: Key Deductions & Losses

Dividends Received Deduction (DRD)

Deduction for dividends received from other domestic corporations. The DRD is the lesser of the percentage of dividends received or the percentage of taxable income.

< 20% Ownership: 50% DRD
20% to < 80% Ownership: 65% DRD
≥ 80% Ownership (Affiliated): 100% DRD

The DRD Net Operating Loss (NOL) Exception Rule

The taxable income limitation does NOT apply if the corporation has a Net Operating Loss (NOL) for the taxable year after deducting the full unconstrained DRD percentage:

Calculate Tentative DRD: 50% or 65% × Dividends Received.
Test for NOL: Subtract Tentative DRD from Taxable Income before DRD.
If Result is Negative (NOL): The taxable income limitation is waived, and the full tentative DRD is allowed.
If Result is Positive: The deduction is limited to the Lesser of: (a) Tentative DRD, or (b) DRD % × Taxable Income before DRD.

Charitable Contributions

Limit & Floor (OBBBA 2026): Deduction is capped at a 10% ceiling of taxable income (computed before DRD, NOL, or capital loss carrybacks). Starting in 2026, C corporations face a 1% taxable income floor on charitable contributions under the One Big Beautiful Bill Act (OBBBA), meaning only donations exceeding 1% of taxable income are deductible, within the existing 10% ceiling.
Timing: Accrued contributions are deductible if paid within 3.5 months of year-end.
Carryover: 5-year carryforward.

Net Operating Losses (NOLs)

NOLs before 2018: Carry back 2 years, carry forward 20 years. Offsets 100% of future income.
NOLs in 2018-2020: Carry back 5 years, carry forward indefinitely. Offsets 100% of future income.
NOLs after 2020: No carryback, carry forward indefinitely. The NOL deduction is limited to 80% of taxable income.

Capital Losses

Corporate capital losses can only be used to offset capital gains.
Carryover rules: They can be carried back 3 years and carried forward 5 years.

Additional Corporate Deductions

Executive Compensation

A publicly held corporation cannot deduct compensation expenses in excess of $1,000,000 paid to its highest-paid employees.

Business Gifts

Deductible up to a maximum of $25 per recipient per year.

Life Insurance Premiums

Corporation as Beneficiary (Key Person): Premiums are not deductible.
Employee as Beneficiary (Fringe Benefit): Premiums are deductible as an employee benefit.

Business Casualty Losses

Partially Destroyed: The loss is the lesser of the change in FMV or the adjusted basis, reduced by any insurance proceeds.
Fully Destroyed: The loss is the adjusted basis less insurance proceeds.

C-Corporation: Special Taxes & Credits

Accumulated Earnings Tax

A penalty tax of 20% on undistributed earnings accumulated beyond reasonable business needs.
C-Corps are entitled to a minimum lifetime credit of $250,000.

Personal Holding Company (PHC) Tax

A penalty tax of 20% on the undistributed income of a PHC. A company is a PHC if it meets both tests:

Ownership Test: More than 50% of the stock is owned by 5 or fewer individuals.
Income Test: 60% or more of adjusted ordinary gross income consists of passive income (Net rent, Royalties, Interest, Dividends).

Foreign Tax Credit

Calculated as the lesser of foreign taxes paid or the US tax liability on foreign income.
Formula: (Worldwide TI * US Rate) * (Foreign TI / Worldwide TI).
Carryover rules: Carry back 1 year, carry forward 10 years.

Penalty Tax Operational Mechanics & Credits

Penalty Tax Program	Trigger Tests & Statutory Rates	Allowable Credits & Exemptions
Accumulated Earnings Tax	20% Penalty Tax on accumulated taxable income exceeding reasonable needs of the business.	$250,000 Lifetime Credit for regular C Corporations ($150,000 for Personal Service Corporations).
Personal Holding Company (PHC) Tax	20% Penalty Tax if both tests met: 1. Ownership: > 50% owned by ≤ 5 individuals during last half of year. 2. Income: ≥ 60% of adjusted ordinary gross income is passive (rents, interest, royalties, dividends).	Self-assessed on Schedule PH (Form 1120). Not subject to Accumulated Earnings Tax if PHC tax applies.

S-Corporations

Eligibility Requirements

Must be a domestic corporation.
Must have only one class of stock (differences in voting rights, like voting vs. non-voting, do not create a second class).
Limited to 100 or fewer shareholders (family members count as a single shareholder).
Eligible shareholders include individuals, estates, and certain trusts.
Ineligible shareholders: Nonresident aliens, C-Corporations, and Partnerships.

Election Timing

To be effective for the current year, Form 2553 must be filed by the 15th day of the 3rd month of the tax year (March 15 for a calendar year).
An election made after this date becomes effective on the first day of the next tax year.

Shareholder Basis & Loss Limitation

Losses are deductible to the extent of the shareholder's basis.
Basis calculation: Stock Basis + Debt Basis (direct loans made by the shareholder to the S-Corp).
Income and losses are allocated to shareholders on a per-share, per-day basis.
Unlike partnership income, passed-through S-Corp earnings are generally not subject to self-employment taxes.

S Corporation Basis Ordering Rules

Step Number & Action	Included Flow-Through Items	Impact on Shareholder Stock Basis
Step 1: Increase for All Income	Ordinary Business Income + Separately Stated Income + Tax-Exempt Income	Increases Stock Basis
Step 2: Decrease for Distributions	Distributions from AAA / Basis (Cannot reduce basis below $0)	Decreases Stock Basis
Step 3: Decrease for Nondeductibles	Nondeductible expenses (fines, penalties, 50% nondeductible meals)	Decreases Stock Basis
Step 4: Decrease for Deductible Losses	Ordinary Business Losses + Separately Stated Capital/§1231 Losses	Decreases Stock Basis to $0 (Excess reduces Debt Basis)

S Corporation Distribution Waterfall (With Prior C Corp E&P)

Tier & Source Account	Tax Impact to Shareholder	Effect on Stock Basis
Tier 1: Accumulated Adjustments Account (AAA)	Nontaxable	Reduces Stock Basis
Tier 2: Prior C Corp Accumulated E&P	Taxable Ordinary Dividend	NO Effect on Basis
Tier 3: Other Adjustments Account (OAA) / Basis	Nontaxable Return of Capital	Reduces Stock Basis to $0
Tier 4: Distributions in Excess of Basis	Taxable Capital Gain (LTCG)	Basis Remains $0

Fringe Benefits

Non-Shareholder Employees & ≤ 2% Shareholders: Benefits are deductible by the S-Corp.
> 2% Shareholders: Benefits are generally not deductible by the S-Corp unless the cost is included in the employee-shareholder's W-2 income.

Separately Stated Items

Items not included in ordinary business income pass through separately to shareholders (e.g., Net rental real estate income/loss, Interest/dividend income, Capital gains/losses, Section 179 deduction, Charitable contributions).

Termination of S-Election

Voluntary: Shareholders holding more than 50% of the stock consent.
Involuntary: Fails to meet any qualification requirement.
Excess Passive Income: More than 25% of gross receipts are from passive income for 3 consecutive years (only applies if the S-Corp has prior C-Corp E&P).

Built-In Gains (BIG) Tax

Imposed at the corporate level when an existing C Corporation converts to an S Corporation and disposes of appreciated assets within the statutory recognition period:

Rule / Parameter	Statutory Mechanism
Recognition Period	5 Years beginning on the effective date of the S corporation election.
Tax Base	Lesser of: (1) Net Recognized Built-In Gain for the tax year, or (2) S-Corp's Taxable Income computed as if it were a C Corporation. Capped at aggregate Net Unrealized Built-In Gain (NUBIG) at conversion date.
Tax Rate	Highest statutory corporate tax rate (21%).
Shareholder Flow-Through	BIG tax paid by the S Corporation is treated as a loss/deduction passing through pro-rata to shareholders with the same character as the underlying gain.

Partnerships

Tax Forms

Form 1065: Informational return filed by the partnership.
Schedule K: Reports the partnership's total income, deductions, credits, etc.
Schedule K-1: Provided to each partner, showing their individual share of the items on Schedule K.

Partner Basis & Loss Limitation

A partner's basis is calculated using their capital account + their share of partnership liabilities.
Losses are deductible only to the extent of this total tax basis.
Withdrawals are nontaxable but decrease the partner's basis.

The 4-Hurdle Partnership Loss Limitation Framework

Sequential Hurdle	Limitation Rule & Disallowed Loss Treatment
1. Outside Tax Basis	Losses limited to total outside tax basis (Capital Account + Share of Recourse and Nonrecourse Debt). Excess carries forward indefinitely until basis increases.
2. At-Risk Amount	Losses limited to cash, basis of property contributed, and recourse debt (excludes general nonrecourse debt). Excess carries forward indefinitely.
3. Passive Activity Limits	If the partner does not materially participate (> 500 hours), loss is passive and can only offset passive income. Suspended losses carry forward.
4. Excess Business Loss (EBL)	Aggregate net business losses are capped. Disallowed excess business loss converts into an NOL carryforward.

Guaranteed Payments

Payments made to a partner for services or use of capital, determined without regard to partnership income.
Partnership Treatment: Deductible as a business expense.
Partner Treatment: Taxable as ordinary income.

Pass-Through Basis Calculations

Understanding how basis flows is critical for both Partnerships and S-Corporations.

$$ \begin{aligned} &\text{Initial Contribution (Cash + Adjusted Basis of Property)} \\ + \; &\text{Share of Ordinary Business Income \& Separately Stated Income} \\ - \; &\text{Cash \& Property Distributions (Non-taxable to extent of basis)} \\ - \; &\underline{\text{Share of Ordinary Losses \& Separately Stated Deductions}} \\ = \; &\textbf{Ending Basis (Before Debt)} \end{aligned} $$

The Impact of Liabilities (Crucial Difference)

Entity	How Debt Affects Basis
Partnership (LLC/LLP)	Included in Tax Basis. A partner's share of the partnership's liabilities (both recourse and nonrecourse) is added directly to their outside tax basis.
S-Corporation	NOT Included in Stock Basis. S-Corp liabilities do not increase a shareholder's stock basis. However, a shareholder can establish a separate Debt Basis only through direct loans made personally by the shareholder to the S-Corp.

Partnership Distributions: Nonliquidating vs. Liquidating

Distribution Feature	Nonliquidating (Current) Distribution	Complete Liquidating Distribution
Partner Gain Recognition	Only if Cash Received > Outside Basis ($0 gain on property distributions).	Only if Cash Received > Outside Basis.
Partner Loss Recognition	$0 Loss Recognized (Never allowed on current distributions).	Loss allowed ONLY if Cash, Unrealized Receivables, and Inventory received is < Outside Basis (and no other assets received).
Basis of Distributed Property	Carryover Basis (Limited to partner's remaining outside basis after cash).	Substituted Basis: Partner's remaining outside basis (after cash) is fully allocated to distributed assets.
Ending Outside Basis	Reduced by cash and basis allocated to property (cannot be < $0).	$0 Ending Outside Basis (Partner interest is terminated).

Sale of Partnership Interest & Section 751 Hot Assets

Calculation Component	Statutory Formula / Requirement	Tax Character
1. Total Realized Gain	Total Realized Gain = (Cash + FMV Property + Debt Relief) − Outside Basis	Overall Economic Gain
2. Section 751 Hot Assets	Partner's pro-rata share of Unrealized Receivables (zero-basis cash receivables, depreciation recapture) + Inventory Items.	Ordinary Income (Cannot be offset by capital losses)
3. Residual Capital Gain / Loss	Capital Gain / Loss = Total Realized Gain − Section 751 Ordinary Income	Capital Gain / Loss

Tax-Exempt Organizations

Most common is a Section 501(c)(3) organization, which is generally exempt from federal income tax.

Unrelated Business Income (UBI)

Exempt organizations may be taxed on UBI if the income meets all three of these conditions:

Derived from a trade or business;
Regularly carried on; and
Not substantially related to the organization's tax-exempt purpose.

Public vs. Private

Public Charities: Receive broad public support (at least 1/3 of total support must be from the public/government). Includes churches, schools, and hospitals.
Private Foundations: Receive support from a single major source and primarily make grants to other organizations. Subject to stricter rules and excise taxes.

UBIT Statutory Exclusions & Form 990-T Requirements

Income / Activity Category	UBIT Status	Statutory Rationale / Exceptions
Passive Investment Income	100% Tax-Exempt (Excluded)	Dividends, interest, annuities, and non-debt-financed capital gains are excluded from UBIT.
Real Property Rents	Tax-Exempt (Excluded)	Rents from real property are excluded unless personal services are provided to occupants or > 50% of rent is from personal property.
Volunteer-Operated Activities	Tax-Exempt (Excluded)	Any trade/business where substantially all work is performed by unpaid volunteers (e.g., charity thrift shops).
Convenience of Members	Tax-Exempt (Excluded)	Activities operated primarily for convenience of members, students, or patients (e.g., university cafeteria/bookstore).
Form 990-T Filing Rule	Mandatory Tax Return	Must file Form 990-T and pay corporate tax rates if gross UBI equals or exceeds $1,000 (Specific $1,000 statutory deduction applies).

State & Local Taxation (SALT)

Nexus

Definition: The minimum level of connection a business must have with a state before it is subject to the state's tax jurisdiction (e.g., owning property, resident employees, or significant sales).
Public Law 86-272 Exception: Protects out-of-state sellers from income tax if their only activity is soliciting orders for tangible personal property.

Apportionment (Business Income)

Business income is apportioned among states where nexus exists, typically using a three-factor formula (though some states heavily weight sales):

$$\text{Property Factor} = \frac{\text{Avg. Property in State}}{\text{Total Property}}$$

$$\text{Payroll Factor} = \frac{\text{Payroll in State}}{\text{Total Payroll}}$$

$$\text{Sales Factor} = \frac{\text{Sales from State Sources}}{\text{Total Sales}}$$

Allocation (Non-Business Income)

Non-business income (e.g., dividends, interest) is allocated entirely to a specific state, usually the state of commercial domicile.

Apportionment & Public Law 86-272

Double-Weighted Sales Apportionment

$$\mathbf{\text{Apportionment Factor}} = \frac{\text{Property Factor} + \text{Payroll Factor} + (2 \times \text{Sales Factor})}{4} \quad \text{(Double-Weighted Sales Model)}$$

Statutory Doctrine	Legal Authority / Scope	Standard for State Taxation
Public Law 86-272 Safe Harbor	Federal Interstate Commerce Statute	Prohibits states from imposing net income tax on out-of-state businesses if their ONLY in-state activity is the solicitation of orders for sales of tangible personal property, sent outside state for approval and filled from outside state. Does not protect services or leasing.
Economic Nexus Standard	South Dakota v. Wayfair (2018)	Physical presence is NOT required. States may impose tax obligations if sales exceed economic thresholds (typically $100,000 in gross revenue OR 200 transactions).

Estates & Trusts Fiduciary Income Taxation (Form 1041)

Estates and trusts are separate taxable entities. Fiduciary income taxation operates under a conduit principle: income distributed to beneficiaries is taxed to the beneficiaries, while retained income is taxed to the estate or trust.

Simple vs. Complex Trusts vs. Decedents' Estates

Entity Classification	Mandatory Distribution	Corpus (Principal) & Charity	Personal Exemption
Simple Trust	Must distribute all current income annually.	Cannot distribute principal; no charitable contributions allowed.	$300
Complex Trust	May accumulate income or distribute at discretion.	May distribute corpus (principal); may make charitable contributions.	$100
Decedent's Estate	Operates until probate assets are fully distributed.	May accumulate or distribute income and principal.	$600

Distributable Net Income (DNI) & Distribution Deduction

DNI determines the maximum deduction allowable to the fiduciary and the maximum amount taxable to beneficiaries on Schedule K-1:

$$\begin{aligned} \text{DNI} &= \text{Taxable Income Before Distribution Deduction} \\ &+ \text{Personal Exemption} \\ &+ \text{Tax-Exempt Interest (Net of Allocable Expenses)} \\ &- \text{Capital Gains Allocated to Corpus} \end{aligned}$$

Rule / Concept	Statutory Mechanism
Income Distribution Deduction	Lesser of: (1) Actual Distributions Made (less tax-exempt income distributed), or (2) DNI (less adjusted tax-exempt interest).
The 65-Day Rule	Trustee can elect to treat distributions made within the first 65 days of the tax year as having been paid on the final day of the preceding tax year.

Professional Responsibilities

Circular 230: Practice Before the IRS

Overview

Circular 230 provides regulations governing practice before the IRS. It covers authority to practice, duties and restrictions, sanctions for violations, and disciplinary proceedings.

Tax Preparer Roles

A tax preparer is anyone who prepares a substantial portion of a tax return for compensation. They must have an IRS Preparer Tax Identification Number (PTIN).

Signing Tax Preparer: The individual with primary responsibility for the overall accuracy of the return.
Non-Signing Tax Preparer: An individual who prepares all or a substantial portion of a return but does not have primary responsibility (e.g., assists the signing preparer).

Key Practitioner Duties & Restrictions

Information to Be Furnished: Must promptly provide records to the IRS, unless believed in good faith to be privileged.
Knowledge of Client Omission: Must advise the client of noncompliance and potential penalties. Not required to notify the IRS or withdraw.
Diligence as to Accuracy: Must exercise due diligence in preparing and filing documents.
Conflicts of Interest: Cannot represent a client if there is a conflict, unless representation is not prohibited by law, the practitioner believes they can competently represent all clients, and all affected clients waive the conflict in writing.
Fees: Cannot charge an "unconscionable fee." Contingent fees are generally not allowed, with exceptions for IRS examinations, refund claims, and judicial proceedings.
Return of Client Records: Must return client records upon request, even if a fee dispute exists.
Practice by Former Government Employees: Subject to strict post-employment representation rules based on prior government responsibilities.

Former Government Employees & Practice Restrictions (Circular 230)

Level of Government Involvement	Scope of Restriction	Duration of Statutory Ban
Personal & Substantial Participation	Cannot represent or assist anyone regarding the specific party matter.	Lifetime Permanent Ban
Official Responsibility (Supervisory)	Cannot represent or assist regarding specific party matters within their direct area of official responsibility during their final year of government service.	2-Year Post-Employment Ban
Drafting / Rulemaking (General Regulations)	Cannot represent or appear before the IRS regarding the specific rule/regulation drafted. (May advise clients internally).	1-Year Post-Employment Ban

Tax Return Position Standards & Penalties

Tax Return Position Standards

Standard	Chance of Success	Use Case
Reasonable Basis	> 20%	Avoids negligence penalty if position is disclosed.
Substantial Authority	~ 40% - 50%	Avoids substantial underpayment penalty even if not disclosed.
More-Likely-Than-Not	> 50%	Required for tax shelters and reportable transactions.

Taxpayer Penalties

Failure-to-File: 5% per month (max 25%). Minimum penalty if >60 days late is lesser of $535 or 100% of tax due.
Failure-to-Pay: 0.5% per month (max 25%).
Substantial Understatement / Negligence: 20% of the understatement. An understatement is "substantial" if it exceeds the greater of 10% of the correct tax or $5,000.
Substantial Valuation Misstatement: 20% penalty if the valuation of property claimed is 150% or more of the correct value (increases to 40% for gross misstatements).
Fraud: Civil penalty is 75% of the understatement (IRS must prove by "preponderance of evidence"). Criminal penalties include fines up to $100,000 ($500,000 for corps) and imprisonment (government must prove "beyond a reasonable doubt").
Earned Income Credit Penalty: Taxpayers who negligently claim the EIC may be disallowed from claiming it for two years (ten years in cases of fraud).

Tax Authoritative Hierarchy & Sources

The determination of a tax position's authority is based on a strict hierarchy. If a conflict occurs, the source higher in the hierarchy governs.

Internal Revenue Code (IRC): Highest Legislative Authority.
Treasury Regulations: Highest Administrative Authority (interprets the IRC).
Revenue Rulings & Procedures: IRS application of the law to specific factual situations.
Private Letter Rulings (PLR): Binding only for the specific requesting taxpayer.

Unsupported Tax Positions

Frivolous Position: A position with less than a 20% chance of success; has no basis in law or authority. Patently improper.
Listed Transaction: A transaction identified by the IRS as a tax avoidance transaction. Strict disclosure is required.

Common Law Duties & Legal Liability

A tax professional can be held civilly liable to clients and, under certain doctrines, to third parties who rely on their work.

Level of Fault	Description & Key Elements	Liability to Third Parties
Breach of Contract	Failure to perform obligations strictly outlined in the engagement letter.	Liable only to the client and named third-party beneficiaries.
Ordinary Negligence	Failure to exercise reasonable/due care. Elements: Duty, Breach, Causation, Damages.	Liable to client and any foreseen/known third parties who relied on the work (Ultramares limits this to primary beneficiaries).
Gross Negligence (Constructive Fraud)	Reckless disregard for the truth or lack of even slight care.	Broad liability to all foreseeable third parties who relied on the work.
Actual Fraud	Intentional misrepresentation. Elements: Material misrepresentation, Scienter (intent to deceive), Intent to induce reliance, Justifiable reliance, Damages.	Broad liability to all foreseeable third parties. Can also carry criminal penalties.

Third-Party Ordinary Negligence Liability: The 3 Competing Legal Standards

Legal Doctrine / Rule	Jurisdiction Scope	Standard for CPA Liability to Third Parties
Ultramares Rule (Privity Rule)	Minority / Traditional Rule (e.g., NY)	CPA is liable for ordinary negligence ONLY to parties in direct privity of contract and named intended third-party primary beneficiaries.
Restatement of Torts (Foreseen Third Parties)	Majority Rule	CPA is liable to a limited, foreseen class of third parties whom the CPA knows will rely on the work for a specific transaction.
Foreseeability Standard (Rosenblum)	Broad Minority Rule (e.g., NJ, MS)	CPA is liable to any reasonably foreseeable third party who relied on the work (broadest exposure).

Taxpayer Privileges & Workpapers

The tax practitioner-taxpayer privilege protects confidential communications but does not apply to criminal cases or tax shelters. Workpapers are the preparer's property but cannot be shared without client consent, except for a valid court subpoena, a quality/peer review, or in defense of a lawsuit.

CPA Workpaper Ownership & Confidentiality Exception Rules

Scenario / Legal Process	Disclosure Rule	Client Consent Required?
Workpaper Property Rights	Workpapers are the sole property of the CPA firm, NOT the client.	N/A (Firm owns files)
Valid Enforceable Subpoena / Court Order	Mandatory Disclosure: CPA must disclose workpapers pursuant to a valid judicial or administrative subpoena.	NO Client Consent Needed
AICPA / State Board Peer Review	Disclosure allowed to official quality review panels.	NO Client Consent Needed
Defense in Legal Action by Client	Disclosure allowed to defend CPA against malpractice claims or disciplinary investigations.	NO Client Consent Needed
Sale of Accounting Practice	Prospective buyer may review confidential records during due diligence, but cannot retain/copy client files without consent.	Confidentiality Agreement Required

Tax Preparer Penalties & Legal Liability

Preparer Conduct Penalties

Understatement due to Unreasonable Position: Penalty is the greater of $1,000 or 50% of the preparer's fee.
Willful or Reckless Conduct (Fraud): Penalty is the greater of $5,000 or 75% of the preparer's fee.
Aiding and Abetting Understatement: Civil penalty of $1,000 for individuals ($10,000 for corporations). IRS has the burden of proof.
Wrongful Disclosure/Use of Information: $250 penalty for each instance (max $10,000). Exceptions include court orders, quality reviews, and client consent.

Preparer Compliance Penalties

Penalty Action	Fine Amount
Failure to sign the return	$60 per failure (max $31,500)
Failure to provide a copy to the taxpayer	$60 per failure (max $31,500)
Failure to furnish an ID number	$60 per failure (max $31,500)
Failure to retain records for 3 years	$60 per failure (max $31,500)
Endorsing a client's refund check	$665 penalty applies

IRS Audits, Appeals, and Courts

Types of Audits

Correspondence Audit: Conducted via mail (common for simple errors or missing documents).
Office Audit: Conducted at a local IRS office.
Field Audit: Conducted at the taxpayer's location/business (most comprehensive).

Selection Methods: Statistical models, random selection, prior year audits, or information return discrepancies (e.g., mismatched 1099s).

Appeals Process

graph TD Audit["Audit Results in Unresolved Issues"] --> Letter30["Issue 30-Day Letter"] Letter30 --> Appeals{"Taxpayer Requests
Admin Appeal?"} Appeals -->|Yes| Conference["IRS Appeals Office Conference"] Conference --> Agreement{"Agreement Reached?"} Appeals -->|No| Letter90["Issue 90-Day Letter (Notice of Deficiency)"] Agreement -->|No| Letter90 Agreement -->|Yes| Resolved["Case Resolved"] Letter90 --> Court["Taxpayer can petition U.S. Tax Court (within 90 days)"]

Trial Courts

U.S. Tax Court: No payment required to petition. No jury trial. Judges are tax experts.
U.S. District Court: Must pay tax first and sue for a refund. Jury trial is an option. Located in taxpayer's geographic area.
U.S. Court of Federal Claims: Must pay tax first. No jury trial.

Federal Tax Trial Courts: Detailed Comparative Analysis

Judicial Feature	U.S. Tax Court	U.S. District Court	U.S. Court of Federal Claims
Prepayment Requirement	NO Prepayment Required (Petition filed within 90 days of Deficiency Notice).	Full Payment Required (Must pay full tax and file refund claim first).	Full Payment Required (Must pay full tax and file refund claim first).
Jury Trial Available?	NO Jury Trial (Tax law specialist judge only).	YES (Jury Available) upon taxpayer request.	NO Jury Trial (16-judge national court).
Appellate Jurisdiction	U.S. Court of Appeals (Taxpayer's Geographic Circuit).	U.S. Court of Appeals (Taxpayer's Geographic Circuit).	U.S. Court of Appeals for the Federal Circuit (Washington, D.C.).
Small Cases Division Option	Yes (≤ $50,000 in dispute; informal, NO Appeal allowed).	No	No

Regulatory Bodies & Legal Concepts

Regulatory Power

State Boards of Accountancy: Have the sole power to grant, suspend, and revoke a CPA's license. Can impose fines and require CPE.
AICPA & State Societies: Can sanction members (e.g., suspend membership), but cannot revoke a CPA's license.
SEC: Can censure, suspend, or revoke the right to practice before the SEC for CPAs.

Burden of Proof

Civil Cases: "Preponderance of the evidence." Generally on the taxpayer.
Criminal Cases: "Beyond a reasonable doubt." On the government.

Standards of Proof & Legal Burdens

Legal Proceeding / Action	Applicable Burden of Proof	Party Bearing Legal Burden
Civil Tax Deficiency (General Rule)	Preponderance of the Evidence (> 50% probability)	Taxpayer (IRS notices carry presumption of correctness).
Civil Tax Fraud	Clear and Convincing Evidence (≈ 75% probability)	Internal Revenue Service (IRS)
Criminal Tax Evasion	Beyond a Reasonable Doubt (≈ 95%+ probability)	Federal Government (DOJ / IRS-CI)
Preparer Aiding & Abetting Penalty	Preponderance of the Evidence	Internal Revenue Service (IRS)

Business Law

Contract Law: Formation & Sources

Methods of Formation

Express Contract: Formed by language, oral or written.
Implied-in-Fact Contract: Formed by conduct.
Unilateral Contract: One promise given in exchange for performance.
Bilateral Contract: Two promises; a promise for a promise.

Sources of Contract Law

Common Law: Governs contracts for services, employment, insurance, and real estate.
Uniform Commercial Code (UCC): Governs contracts for the sale of goods (moveable tangible property).

Contract Law: Enforceability & Remedies

Elements of an Enforceable Contract

Agreement: Offer and Acceptance (Mutual Assent).
Consideration: Bargained-for exchange of legal value. (Pre-existing duties do not count).
Lack of Defenses: Must be free from fraud, duress, illegality, etc.

Breach & Substitution Doctrines

Concept	Definition & Impact on Parties
Major vs. Minor Breach	Major: Substantial breach. Discharges non-breaching party; can sue for damages. Minor: Does not discharge the non-breaching party, but allows suit for damages.
Accord & Satisfaction	An agreement to substitute one contract for another (Accord), followed by the execution of that new agreement (Satisfaction).
Novation	A new party is substituted for an old party in an existing contract, releasing the old party from liability.

Remedies for Breach

Remedy	Application
Compensatory Damages	Standard remedy; puts the non-breaching party in the financial position they would have been in had the contract been fulfilled.
Specific Performance	Court orders the breaching party to perform. Used only when monetary damages are inadequate (e.g., unique items, land). Cannot be used for personal services.
Liquidated Damages	A clause specifying damages in advance. Enforceable only if it is a reasonable estimate and not designed as a penalty.

UCC Article 2 Commercial Remedies & Damages Framework

Aggrieved Party	Remedy Type	Statutory Formula / Standard
Buyer's Remedy (Seller Breaches)	Cover Damages	Damages = (Cover Price − Contract Price) + Incidentals & Consequentials − Expenses Saved
Buyer's Remedy (No Cover)	Market Damages	Damages = (Market Price at Tender − Contract Price) + Incidentals
Seller's Remedy (Buyer Breaches)	Resale Damages	Damages = (Contract Price − Resale Price) + Incidentals − Expenses Saved
Seller's Remedy (Lost Volume Seller)	Lost Profits	Damages = Lost Profit (including overhead) + Incidentals
Seller's Remedy (Full Price)	Action for the Price	Allowed ONLY if goods cannot be reasonably resold (e.g., custom manufactured) or were destroyed after risk of loss passed.

Contract Law: The Offer & Acceptance

The Offer

Must be a serious offer with definite and certain terms. Advertisements are generally invitations, not offers.

Termination of Offer:

Revocation by Offeror: Effective when received by the offeree. An option contract (consideration paid to keep offer open) is irrevocable.
Rejection by Offeree: A counteroffer is a rejection. Effective when received by the offeror.
By Operation of Law: Death or incompetency of parties, destruction of subject matter, or illegality.

The Acceptance

Mailbox Rule: Acceptance is effective when SENT (dispatched), regardless of when it is received.
Common Law (Mirror Image Rule): Acceptance must exactly mirror the offer's terms.
UCC (Sale of Goods): Mirror Image Rule does not apply. Minor changes are acceptable.

Contract Formation Comparison: Common Law vs. UCC Article 2

Formation Rule	Common Law (Real Estate, Services)	UCC Article 2 (Sale of Moveable Goods)
Firm Offer Rule	Revocable unless supported by consideration (Option Contract).	Merchant's Firm Offer: Written & signed offer by merchant is irrevocable without consideration for stated time (or up to 3 months max).
Mirror Image Rule	Strict compliance required. Any alteration in terms is a Counteroffer / Rejection.	Abolished: Acceptance with minor/different terms is valid unless expressly conditional on assent. Between merchants, new terms become part of contract unless objected to or materially alter deal.
Contract Modifications	Requires new consideration to be enforceable (Pre-existing legal duty rule).	No consideration required for modifications made in good faith.

Contract Law: Defenses

Defense	Effect on Contract	Description & Key Rules
Fraud	Void or Voidable	Fraud in the Execution: Void (the party did not know it was a contract). Fraud in the Inducement: Voidable (the party knew it was a contract but terms were misrepresented). Must prove misrepresentation of material fact, scienter, intent, reliance, and damages.
Duress	Void or Voidable	Physical threats make a contract Void. Economic or social threats make a contract Voidable.
Mutual Mistake	Voidable	A mistake made by both parties regarding a material fact of the contract.
Illegality	Void	If the subject matter is illegal, it is void. Note: Contracts with workers lacking a Revenue-Raising license are valid; those lacking a Public Protection license (e.g., CPA, Doctor) are void.
Incapacity	Void or Voidable	Contracts with minors are voidable. Contracts with adjudicated incompetent individuals are void.
Statute of Frauds	Unenforceable if oral	Must be in writing to be enforceable: • Marriage agreements • Contracts that cannot be completed within one year • Real estate/land sales and leases over one year • Promises by an executor to personally pay estate debts • Sales of goods $500 or more (Exceptions: Custom goods, merchant 10-day rule, court admission, or performed goods) • Guarantor/Surety promises
Impossibility	Discharged	Events occurring after formation make performance objectively impossible.

Void vs. Voidable Contract Defenses: Definitive Classification

Classification	Legal Effect	Specific Qualifying Defenses (CPA Exam Tested)
VOID (Nullity from Inception)	Cannot be enforced or ratified by either party; treated as never existing.	• Fraud in the Factum / Execution (unaware of signing contract) • Physical Duress (force or threat of physical harm) • Illegality (regulatory/public protection licensing violations) • Adjudicated Incompetence / Insanity (prior court determination)
VOIDABLE (Injured Party Option)	Valid contract that can be rescinded or ratified at election of aggrieved party.	• Fraud in the Inducement (misrepresentation of terms) • Economic / Social Duress or Undue Influence • Mutual Mistake of Material Fact • Minority Status / Incapacity (unadjudicated intoxication or under age 18)

UCC Article 2 Statute of Frauds: Exceptions to Writing Rule ($500+ Goods)

Contracts for the sale of goods ≥ $500 must generally be in writing to be enforceable, EXCEPT in the following statutory circumstances:

Specially Manufactured Goods: Custom goods specifically manufactured for the buyer that are not suitable for sale to others in the ordinary course of business, once manufacture has substantially begun.
Written Merchant Confirmation (10-Day Rule): Between merchants, if one party sends a written confirmation sufficient against the sender, the recipient is bound unless written objection is given within 10 days of receipt.
Judicial Admission in Pleadings or Testimony: The party against whom enforcement is sought admits in court pleadings, testimony, or discovery that a contract was formed (enforceable up to the quantity admitted).
Part Performance / Partial Payment: The contract is enforceable with respect to goods for which payment has been made and accepted, or which have been received and accepted.

UCC Article 2: Risk of Loss & Commercial Warranties

Risk of Loss Rules in Sales of Goods

Shipping Term / Scenario	When Risk of Loss Transfers to Buyer	Key Legal Consequence
FOB Shipping Point (Carrier Contract)	Transfers when seller delivers goods to the common carrier.	Buyer bears risk during transit and must file transit insurance claims.
FOB Destination (Destination Contract)	Transfers when goods reach the buyer's specific destination and are tendered.	Seller bears all risk of destruction during transit.
Non-Carrier: Merchant Seller	Transfers upon actual physical receipt by the buyer.	Merchant seller bears risk until buyer takes physical possession.
Non-Carrier: Non-Merchant Seller	Transfers upon tender of delivery (goods made available).	Buyer bears risk once goods are available for pickup.
Nonconforming Goods Tendered	Risk of loss remains on SELLER until cured or accepted.	Breach prevents risk from passing, regardless of shipping terms.

UCC Article 2 Commercial Warranties Comparison

Warranty Type	Merchant Status Required?	Creation & Disclaimer Requirements
Express Warranty	No (Any Seller)	Created by statement of fact, promise, description, or sample. Cannot be disclaimed by general disclaimers.
Implied Warranty of Merchantability	YES (Merchants Only)	Goods fit for ordinary purpose. Disclaimed orally or in writing mentioning "Merchantability" or with "as is" / "with all faults".
Implied Warranty of Fitness for Particular Purpose	No (Any Seller)	Seller knows buyer's specific purpose and buyer relies on seller's expertise. Must be disclaimed in conspicuous writing.
Warranty of Title	No (Any Seller)	Good title, rightful transfer, no unstated liens. Disclaimed only by specific language or circumstances.

Agency Law

Agent's Power to Bind Principal

Authority Type	Source of Power	Description
Actual Authority	Power + Right	Can be Express (written/oral) or Implied (reasonably necessary to carry out express duties).
Apparent Authority	Power Only	Created by the principal's words/actions that cause a third party to reasonably believe the agent has authority.
Agency by Estoppel	Legal Doctrine	If a principal allows a 3rd party to believe an agency exists, they are "estopped" from denying it later to avoid liability.
Ratification	After-the-Fact	No initial power or right. The principal affirms an unauthorized act after it has occurred, binding themselves to it.

Duties of Agent to Principal

Duty	Agent's Requirement
Loyalty	Act solely for the principal's benefit. No self-dealing, secret profits, or representing both sides without consent.
Obedience	Follow all lawful and reasonable instructions provided by the principal.
Reasonable Care	Perform tasks with the expected degree of care, skill, and diligence.
Account	Keep accurate records of all money/property. Must not commingle funds.
Inform / Notify	Disclose all significant, relevant information to the principal promptly.

Termination of Agency

Actual authority terminates by acts of the parties (quitting, firing) or operation of law (death, bankruptcy). Apparent authority only terminates once notice is given to third parties.

Contractual Liability by Principal Disclosure Status

Principal Disclosure Type	Third Party Knowledge	Is Principal Bound / Liable?	Is Agent Bound / Liable?
Disclosed Principal	Knows agent acts for a principal AND knows principal's identity.	YES (If actual or apparent authority exists)	NO (Agent is not a party to the contract).
Partially Disclosed (Unidentified)	Knows agent acts for a principal, but DOES NOT know identity.	YES (Liable upon identification)	YES (Liable) (3rd party can elect to hold agent liable).
Undisclosed Principal	Believes agent is acting on agent's own personal behalf.	YES (Liable upon identification)	YES (Liable) (Personally liable on the contract).

Termination of Agency & Respondeat Superior Scope

Legal Dimension	Rule of Law	Third-Party Notice Requirement
Termination by Acts of Parties	Revocation, renunciation, fulfillment of purpose, expiration of term.	Actual Notice required for existing customers; Constructive Notice (newspaper/trade pub) for all other 3rd parties.
Termination by Operation of Law	Death or insanity of either party, bankruptcy of principal, loss of license.	Terminates Immediately & Automatically. NO notice to third parties is required; apparent authority is destroyed.
Respondeat Superior (Employer Liability)	Employer strictly liable for employee torts committed within scope of employment (Detour = liable; Frolic = not liable).	Employer is NOT liable for independent contractor torts (unless inherently dangerous activity or nondelegable duty).

Surety Law

Surety vs. Guarantor

Surety: Directly liable on the debt. The creditor can proceed directly against the surety upon the debtor's default.
Guarantor: Liable only if the creditor first tries and fails to collect from the debtor.

Surety's Rights

Exoneration: Can compel the debtor to pay before the surety has to pay.
Subrogation: After paying, the surety acquires all the creditor's rights against the debtor.
Reimbursement: Can recover from the debtor any amount the surety paid.

Surety's Defenses

A surety can use defenses like fraud by the creditor, duress upon the debtor, illegality of the underlying obligation, and discharge of the debtor's obligation. A surety's own incapacity or bankruptcy is also a defense.

Compensated vs. Gratuitous Suretyship & Creditor Actions

Creditor Action / Contract Modification	Compensated Surety (Bonding Co.)	Gratuitous (Uncompensated) Surety
Material Modification of Contract Terms	Discharged ONLY IF modification materially increases risk of loss.	100% Discharged by ANY modification (even minor/beneficial).
Creditor Releases Collateral	Discharged pro-rata to the extent of the value of collateral released.	Discharged pro-rata to the extent of the value of collateral released.
Creditor Releases Debtor	Discharged unless creditor expressly reserves rights against surety.	Discharged completely.

Co-Surety Right of Contribution & Defenses

$$\text{Co-Surety Contribution} = \text{Amount Paid} \times \left( \frac{\text{Co-Surety's Agreed Limit}}{\text{Total Limits of All Solvent Co-Sureties}} \right)$$

Suretyship Defenses: Discharges vs. Ineffective Defenses

Valid Defenses (Discharging Surety): Creditor fraud, misrepresentation, or bad faith; Full payment or tender of performance by debtor; Release of the principal debtor without reservation of rights; Surety's own bankruptcy, incapacity, or minority.
Ineffective Defenses (Surety Remains Liable): Principal debtor's bankruptcy or discharge in bankruptcy; Principal debtor's death, insolvency, or incapacity; Principal debtor's fraud or misrepresentation inducing surety to sign (unless creditor was aware).

Secured Transactions (UCC Article 9)

Governs debtor-creditor relationships where personal property (collateral) is used to secure a debt.

Secured vs. Unsecured Creditor

Unsecured Creditor: Has no specific claim to the debtor's property. If the debtor defaults, the creditor must sue, obtain a judgment, and execute it.
Secured Creditor: Has a legal interest (security interest) in specific personal property. Can repossess the collateral upon default without a court judgment (if done without breaching the peace).

Attachment vs. Perfection

Process	Purpose	Requirements
Attachment	Establishes the creditor's rights against the debtor.	Must have all three: 1. Agreement (written or creditor takes possession). 2. Creditor gives value. 3. Debtor has rights in the collateral.
Perfection	Establishes the creditor's priority over third parties.	Must attach first, then achieve one of the following: 1. Filing a Financing Statement. 2. Possession of collateral. 3. Control. 4. Automatic Perfection (e.g., PMSI in consumer goods).

Securities Act of 1933: Registration & Exemptions

Requires investors to receive financial and other significant information concerning securities being offered for public sale; prohibits deceit, misrepresentations, and other fraud in sales.

Exempt Securities (Never Require Registration)

Securities issued by banks/savings and loans, government/municipal bonds, nonprofit charitable organizations, common carriers (railroads), and short-term commercial paper (≤ 9 months maturity).

Transaction Exemptions: Regulation D (Rules 504 & 506) & Crowdfunding

Exemption Framework	Dollar Cap (12-Month Period)	Investor Limitations & Solicitation Rules
Rule 504	$10,000,000	No limit on number or type of purchasers. General advertising permitted under specific state law exemptions.
Rule 506(b)	Unlimited Dollar Amount	Unlimited accredited investors + up to 35 sophisticated non-accredited investors. NO general solicitation permitted.
Rule 506(c)	Unlimited Dollar Amount	100% Accredited Investors ONLY. General solicitation and advertising permitted (issuer must verify status).
Regulation Crowdfunding	$5,000,000	Must conduct offering via single registered online intermediary / portal. Individual investment limits apply to non-accredited investors.
Regulation A (Tier 2)	$75,000,000	Requires offering circular and audited financial statements. Non-accredited investor caps apply.

Securities Liability: 1933 Act §11 vs. 1934 Act Rule 10b-5 & §16(b)

Statutory Provision	Scienter Required?	Plaintiff Reliance Required?	Auditor / Defendant Primary Defenses
Section 11 (1933 Act) Defective Registration Statement	NO Scienter Required (Strict liability for issuer; negligence standard for CPAs/underwriters)	NO Reliance Required (Plaintiff must prove only: acquired stock, material misstatement, damages)	• Due Diligence Defense: Conducted reasonable investigation and believed statements were true. • Loss Causation: Decline caused by factors other than misstatement.
Rule 10b-5 (1934 Act) Antifraud Provisions	YES (Scienter Mandatory) (Intent to deceive, manipulate, defraud, or reckless disregard)	YES (Reliance Required) (Plaintiff must prove justifiable reliance and damages)	• Good Faith: Absence of scienter / lack of reckless conduct. • No material misrepresentation or omission.
Section 16(b) (1934 Act) Short-Swing Profits	NO (Strict Liability)	NO Reliance Needed	Mandatory forfeiture of all profits from purchase/sale within 6 months by officers, directors, and > 10% shareholders.

Key Bankruptcy Concepts (U.S. Code)

Types of Bankruptcy & Eligibility

Chapter 7 (Liquidation): Trustee liquidates non-exempt assets to distribute proceeds. Available to individuals, partnerships, and corporations. Excludes: railroads, insurance companies, banks, and small business investment companies.
Chapter 11 (Reorganization): Debtor continues operating while developing a repayment plan. Excludes: stockbrokers and commodity brokers.
Chapter 13 (Individual Debt Adjustment): Individual with regular income creates a 3- to 5-year repayment plan.
Chapter 9: Municipal Debt Adjustment.
Chapter 12: Family Farmers with Regular Income.

Key Features of Bankruptcy Proceedings

Automatic Stay: Injunction halting most collection activities against the debtor.
Section 341 Meeting: A mandatory meeting of creditors held during proceedings.
Property of the Estate: Includes all assets at filing, plus inheritances, life insurance payouts, or divorce settlements received within 180 days after filing.
Preferential Payments: Trustee can recover payments made to a creditor within 90 days before filing (or 1 year for an insider) that allowed the creditor to receive more than they would have in bankruptcy.

Involuntary Bankruptcy Petition Thresholds

Debtor's Total Unsecured Creditors	Minimum Number of Creditors Required to File	Aggregate Unsecured Debt Threshold
< 12 Creditors	At least 1 creditor with unsecured claim	Must hold at least $18,600 in undisputed unsecured claims.
≥ 12 Creditors	At least 3 creditors joining the petition	Must aggregate at least $18,600 in undisputed unsecured claims.

Bankruptcy Priority Unsecured Claims Waterfall

Claim Category	Description & Statutory Dollar Limits
1st: Domestic Support Obligations	Child support and alimony obligations.
2nd: Administrative Expenses	Direct costs of preserving, administering, and liquidating the bankruptcy estate (legal, accounting, trustee fees).
3rd: Involuntary "Gap" Creditors	Ordinary course business claims arising between involuntary petition filing and order for relief.
4th: Wage & Salary Claims	Unpaid wages, salaries, and commissions earned within 180 days prior to filing, capped at $15,150 per employee.
5th: Employee Benefit Contributions	Unpaid benefit plan contributions within 180 days (capped at $15,150 per employee minus wage claims paid).
6th: Grain Producers & US Fishermen	Unsecured claims against grain storage or fish processing facilities, capped at $7,475 per claimant.
7th: Consumer Deposits	Prepayments for unrendered consumer goods, services, or leases, capped at $3,350 per claimant.
8th: Tax Claims	Unpaid federal, state, and local income, gross receipts, and employment taxes.
9th: Intoxicated Driving Claims	Claims for personal injury or wrongful death resulting from debtor's unlawful operation of motor vehicle, vessel, or aircraft while intoxicated.

Non-Dischargeable Debts & Preferential Transfers

Concept	Statutory Elements & Testing Rules	Exceptions / Defenses
Non-Dischargeable Individual Debts	• Willful & Malicious Injury: Liabilities arising from intentional torts and DUI injuries. • Alimony & Child Support: Domestic support obligations. • Fraud, Embezzlement, & Fines: Debts obtained by false pretenses, larceny, embezzlement, or governmental fines/penalties. • Taxes: Federal/state income taxes due within 3 years or unfiled/fraudulent returns. • Educational Loans: Student loans (unless debtor proves undue hardship). • Unscheduled Debts: Debts not timely listed on bankruptcy schedule.	Debtor remains 100% personally liable post-discharge.
Preferential Transfer (Voidable Preference)	1. Transfer to/for benefit of creditor on antecedent debt; 2. Made while debtor was insolvent; 3. Made within 90 days before filing (or 1 year for insiders); 4. Creditor receives more than in Chapter 7 liquidation.	NOT Preferences: • Contemporaneous exchange for new value • Payments in ordinary course of business • Consumer debt payments < $600 • Domestic support obligations

Chapter 7 Means Testing & Median Income Formula

$$\text{Disposable Monthly Income} = \text{Current Monthly Income (CMI)} - \text{IRS Standard Living Expenses} - \text{Mandatory Debt Payments}$$

60-Month Aggregate Disposable Income	Presumption of Abuse Result	Bankruptcy Case Action
< $9,075 ($151.25 / month)	No Presumption of Abuse	Taxpayer is eligible to file Chapter 7 Liquidation.
$9,075 to $15,150	Abuse presumed ONLY IF disposable income ≥ 25% of nonpriority unsecured debt.	Case dismissed or converted to Chapter 13 plan.
> $15,150 ($252.50 / month)	Automatic Presumption of Abuse	Must convert to Chapter 13 repayment plan or face dismissal.

Business Entities Summary & Corporate Doctrines

Feature	Sole Prop.	General Partnership	LLP	Limited Partnership	LLC	S-Corp	C-Corp
Formation	No Formalities	No Formalities	File Statement	File Certificate	File Articles	File Articles	File Articles
Liability	Unlimited	Unlimited	Limited (own negligence)	GP: Unlimited; LP: Limited	Limited	Limited	Limited
Management	Owner	Partners	Partners	General Partners only	Members or Managers	Board of Directors	Board of Directors
Transferability	Freely	Requires consent	Requires consent	Requires consent	Requires consent	Freely	Freely
Taxation	Flow-Through	Flow-Through	Flow-Through	Flow-Through	Flow-Through	Flow-Through	Double Taxation

Corporate Doctrines

Piercing the Corporate Veil: Courts may disregard the corporate structure and hold shareholders personally liable if the entity is used improperly (e.g., commingling personal with corporate funds, inadequate capitalization, fraud).
Ultra Vires Act: An act by a corporation that is beyond the scope of its powers as defined in its articles of incorporation.

Corporate Governance, Fiduciary Duties & Ultra Vires Doctrine

Governance Concept	Legal Definition & Standard	Remedies / Shareholder Action
Business Judgment Rule (BJR)	Directors/officers are immune from liability for business decisions made in good faith, with due care, and without conflicts of interest, even if the decision results in substantial financial loss.	Protects management from ordinary negligence claims.
Duty of Loyalty	Prohibits directors/officers from self-dealing, usurping corporate opportunities, or competing directly with the corporation.	Transactions are voidable unless approved by disinterested board members / shareholders after full disclosure or proven fair to corporation.
Ultra Vires Acts	Corporate actions that exceed the express statutory purpose or power stated in the Articles of Incorporation.	• Shareholders may sue for an injunction. • Corporation/shareholders may sue officers/directors for damages. • State Attorney General may dissolve corporation.
Derivative Lawsuit	Shareholder sues on behalf of the corporation against directors/third parties to enforce a corporate right.	Any recovery/damages awarded goes directly to the corporation (not the suing shareholder).

Federal Laws & Regulations

Regulation / Topic	Key Rules & Employer/Employee Impact
FICA (Social Security)	Funded 6.2% by the employer and 6.2% by the employee on wages up to a limit. Income includes salaries, bonuses, and commissions (excludes gifts).
FUTA (Unemployment)	Employer-only tax. Paid if the employer has quarterly payrolls of $1,500+ or employs someone for 20 weeks a year. Explicitly excludes self-employed individuals.
Worker Classification	Classification as an employee versus an independent contractor heavily relies on the degree of control the business has over the worker's behavior and financial independence.
Workers' Compensation	State-run, no-fault insurance for on-the-job injuries, fully funded by the employer. It only covers employees acting within the scope of their employment.
Affordable Care Act (ACA)	Applicable Large Employers (50+ FT employees) must offer affordable health coverage to 95% of FT employees. • Penalty 1: Fails to offer minimum essential coverage. • Penalty 2: Coverage offered is unaffordable or inadequate.
Foreign Corrupt Practices Act (FCPA)	Prohibits U.S. businesses and their agents from bribing foreign officials to obtain or retain business. Requires proper internal accounting controls.

Affordable Care Act (ACA) Employer Shared Responsibility Penalties

Statutory Penalty Type	Trigger Event	Annual Statutory Formula
Penalty A No Coverage Offered	Applicable Large Employer (ALE ≥ 50 FT staff) fails to offer Minimum Essential Coverage (MEC) to ≥ 95% of FT employees and at least 1 employee receives premium tax credit.	Penalty = $2,970 × (Total FT Employees − 30)
Penalty B Unaffordable / Inadequate	ALE offers coverage, but it is unaffordable or fails Minimum Value (60%), and employee receives premium tax credit on Exchange.	Penalty = $4,460 × (FT Employees Receiving Tax Credit) (Capped at Penalty A maximum)

Federal Unemployment Tax (FUTA) & Workers' Compensation Statutory Rules

Employment Law Program	Statutory Tax Rate & Wage Base	State Credit & Liability Mechanics
FUTA (Employer-Paid Tax)	6.0% Statutory Rate on first $7,000 of annual wages per employee.	State Tax Credit: Up to 5.4% maximum credit for timely paid state unemployment taxes, reducing the net federal FUTA rate to 0.6% ($42/employee).
Workers' Compensation (State Mandated)	Strict liability system funded 100% by employer insurance premiums (Deductible business expense).	Exclusive Remedy Rule: Employee cannot sue employer for ordinary negligence for job-related injuries. (Exception: Intentional employer torts).