fbpx

REG CPA Practice Questions Explained: Taxation of Income from Disregarded Entities

Taxation of Income from Disregarded Entities

Share This...

In this video, we walk through 5 REG practice questions demonstrating the taxation of income from disregarded entities.

These questions are from REG content area 4 on the AICPA CPA exam blueprints: Federal Taxation of Individuals.

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

Also be sure to watch one of our free webinars on the 6 “key ingredients” to an extremely effective & efficient CPA study process here…

Click here to watch the video on YouTube…

The Taxation of Income from Disregarded Entities

Reporting income from disregarded entities, such as single-member LLCs (SMLLCs) and sole proprietorships, on an individual’s tax return involves understanding how these entities are treated for tax purposes and identifying the correct forms and schedules to use.

Understanding Disregarded Entities

First, it’s important to understand what a disregarded entity is. In the context of U.S. federal tax law, a disregarded entity is a business entity that is not separate from its owner for income tax purposes. This means that the entity itself does not pay income taxes; instead, all of its income, deductions, and credits are the responsibility of its owner who reports these items on their personal tax return.

Single-member LLCs and sole proprietorships are typical examples of disregarded entities. Unless the single-member LLC elects to be taxed as a corporation, it is automatically considered a disregarded entity.

Reporting Ordinary Business Income (Loss)

  1. Schedule C (Form 1040 or 1040-SR): Both sole proprietors and single-member LLCs generally report their business income and expenses on Schedule C (Profit or Loss from Business). This schedule requires detailed information about the business’s revenue, cost of goods sold (if applicable), and expenses. The net result (profit or loss) calculated on Schedule C is then transferred to Form 1040 or 1040-SR, where it’s combined with other income and deductions to determine the taxpayer’s total tax liability.
  2. Self-Employment Tax: If the net earnings from the business (reported on Schedule C) are $400 or more, the individual must also file Schedule SE (Self-Employment Tax) to calculate the self-employment tax owed. Self-employment tax is a Social Security and Medicare tax primarily for individuals who work for themselves. It’s similar to the Social Security and Medicare taxes withheld from the pay of most wage earners.

Reporting Separately Stated Items

Certain business-related items must be reported separately from the ordinary business income because they are subject to different tax rules.

  • Real estate income,
  • Dividends,
  • Interest,
  • Capital gains and losses,
  • Charitable contributions,
  • Section 179 deductions,
  • Rental income or loss.

However, for a single-member LLC or a sole proprietorship, most separately stated items will still be reported on Schedule C or the relevant schedules and forms depending on the type of income or deduction. For example, capital gains and losses are reported on Schedule D, and rental income or loss is reported on Schedule E.

Example:

Alex runs a catering service as a sole proprietor. For the tax year, Alex’s financials are as follows:

  • Gross Income (Total Sales): $50,000
  • Expenses:
    • Food Supplies: $15,000
    • Equipment Rental: $5,000
    • Marketing: $2,000
    • Insurance: $3,000

Completing Schedule C

  1. Report Gross Income: Alex enters $50,000 as the gross income on Schedule C.
  2. List and Subtract Expenses: Alex lists all business expenses and calculates the total:
    • Food Supplies: $15,000
    • Equipment Rental: $5,000
    • Marketing: $2,000
    • Insurance: $3,000 Total Expenses = $25,000
  3. Calculate Net Profit: Alex subtracts the total expenses ($25,000) from the gross income ($50,000) to find the net profit, which is $25,000.

Reporting Income on Form 1040

  • Transfer Income: The net profit of $25,000 from Schedule C is Alex’s business income. This amount is then reported on Alex’s Form 1040 as part of his total income.

Other Posts You'll Like...

Want to Pass as Fast as Possible?

(and avoid failing sections?)

Watch one of our free "Study Hacks" trainings for a free walkthrough of the SuperfastCPA study methods that have helped so many candidates pass their sections faster and avoid failing scores...