REG II: taxation of individuals, entities and property

The tax areas of REG, the taxation of property transactions, individuals and entities, carry about two thirds of the section's weight. They test computation more than any other part of the exam: gross income, adjustments, deductions, credits, basis, gains and losses, and the taxation of C corporations, S corporations, partnerships and trusts. This lesson reviews these topics through the Brandt family from ACCT-351 and ACCT-352: Leah Brandt, a quality engineer in Des Moines with a drone business, Brandt Aerial, which she later runs as an LLC electing S corporation status, and SkyGrid Data LLC, the partnership she formed with Dev Mehta. Figures for 2026 are those used in those courses, checked in October 2026.

Individual taxation: the structure of the return

Every individual question follows the same structure: gross income, less adjustments for adjusted gross income (AGI), less the standard deduction or itemized deductions and the qualified business income deduction, gives taxable income; tax at the applicable rates, less credits, plus other taxes such as self-employment tax and the net investment income tax, gives total tax, less payments and withholding. Know what is included in gross income (wages, interest, dividends, business and rental income, gains, alimony under pre-2019 agreements, prizes) and what is excluded (municipal bond interest, gifts and inheritances, certain employer-provided benefits, life insurance proceeds and the gain on a principal residence up to the section 121 limits).

Know the deductions and credits that the exam tests repeatedly. Adjustments include half of self-employment tax, contributions to traditional IRAs and health savings accounts, student loan interest and self-employed retirement contributions. Itemized deductions include medical expenses above 7.5 percent of AGI, state and local taxes up to the cap (40,400 dollars for 2026, phased down above 505,000 dollars of income under the 2025 tax act, as ACCT-351 verified), home mortgage interest and charitable contributions subject to AGI limits. Credits include the child tax credit, the earned income credit, education credits and the credit for child and dependent care. The 2025 act also introduced deductions for certain tips, overtime pay and seniors for 2025 through 2028; confirm their testable dates.

Property transactions

Property questions test basis, gain and loss, and character. Basis starts at cost, increases with improvements and decreases with depreciation. Property received by gift generally takes the donor's basis, with a special rule for losses when fair value is below the donor's basis; property inherited takes a basis equal to fair value at death. Gains and losses are capital or ordinary: capital assets held more than a year give long-term gains taxed at 0, 15 or 20 percent; depreciable business property held more than a year is section 1231 property, whose net gains are capital and net losses ordinary, subject to depreciation recapture under section 1245 for personal property and the unrecaptured section 1250 rules for real property. Like-kind exchanges under section 1031 are limited to real property and defer gain except to the extent of boot received. Wash sales disallow losses on securities repurchased within 30 days before or after the sale.

Entity taxation: choosing a structure

REG compares the taxation of C corporations, S corporations, partnerships and sole proprietorships. A C corporation pays tax at a flat 21 percent, and its shareholders pay tax again on dividends, so income is taxed twice. A sole proprietor pays income tax and self-employment tax on all business profit. An S corporation's income passes through to shareholders, avoiding the corporate tax, and only wages paid to shareholder-employees are subject to payroll taxes, provided the wages are reasonable. Partnerships also pass through income, and a general partner's distributive share of ordinary business income is generally subject to self-employment tax. The qualified business income deduction under section 199A, made permanent by the 2025 tax act, applies to pass-through income subject to limits for high earners and specified service businesses.

The program below compares the payroll tax burden of running Brandt Aerial as a sole proprietorship and as an S corporation with 120,000 dollars of net profit, using the 2026 Social Security wage base of 184,500 dollars, and computes Leah's outside basis in SkyGrid Data after a distribution. It is a simplified illustration; ACCT-352 computed the full entity comparison, which found total tax of about 40,385 dollars as a sole proprietorship, 31,301 as an S corporation and 44,799 as a C corporation for the case facts.

# REG II: Brandt Aerial (from ACCT-351/352) as a sole proprietorship or an S corporation.
# 2026 Social Security wage base of 184,500 dollars; illustrative figures, not a full return.
net = 120000
se_base = net * 0.9235
se_tax = min(se_base, 184500) * 0.124 + se_base * 0.029
print(f"Sole proprietorship: SE tax {se_tax:,.0f} on {net:,} of net earnings")
for wage in (60000, 80000):
    payroll = wage * 0.153
    print(f"S corporation, wage {wage:,}: payroll taxes {payroll:,.0f}; "
          f"distribution {net - wage - wage * 0.0765:,.0f} free of payroll tax")
print("Reasonable compensation is a facts-and-circumstances test (see Watson).")
# Partnership basis (SkyGrid Data LLC, from ACCT-352)
basis = 55000 + 23000 - 12000     # opening + share of income - distributions
print(f"Leah's outside basis after a 12,000 distribution: {basis:,}")

Sole proprietorship: SE tax 16,955 on 120,000 of net earnings
S corporation, wage 60,000: payroll taxes 9,180; distribution 55,410 free of payroll tax
S corporation, wage 80,000: payroll taxes 12,240; distribution 33,880 free of payroll tax
Reasonable compensation is a facts-and-circumstances test (see Watson).
Leah's outside basis after a 12,000 distribution: 66,000

Self-employment tax on 120,000 dollars of net earnings is about 16,955 dollars. As an S corporation paying Leah a wage of 60,000 dollars, payroll taxes on the wage, counting both the employer and employee shares, are 9,180 dollars, and the rest of the profit is distributed free of payroll tax. A higher wage of 80,000 dollars costs more payroll tax but is easier to defend as reasonable compensation. The Watson case, in which the court reclassified distributions to an accountant as wages because his salary of 24,000 dollars was far below the roughly 91,000 dollars a comparable professional would earn, is the standard reminder that the wage must reflect the services provided.

S corporations and partnerships in detail

S corporation questions test eligibility (a domestic corporation with no more than 100 shareholders, only individuals, estates and certain trusts as shareholders, no nonresident aliens and one class of stock), the election on Form 2553, shareholder basis (stock basis increased by income and decreased by distributions and losses, plus debt basis for loans the shareholder makes), the order in which distributions are treated, the accumulated adjustments account, and the built-in gains tax on corporations that converted from C status. Partnership questions test contributions under section 721 (generally tax-free), the partner's outside basis (contributions plus share of income and liabilities, less distributions and share of losses), guaranteed payments, special allocations with substantial economic effect, the treatment of distributions and the disposition of an interest, including hot assets under section 751. SkyGrid's 23,000 dollar share of income increases Leah's outside basis from 55,000 to 78,000 dollars, and a 12,000 dollar distribution reduces it to 66,000.

C corporations and other entities

C corporation questions test the computation of taxable income and the reconciliation from book income on Schedule M-1 or M-3: book-tax differences such as federal income tax expense, nondeductible fines and penalties, 50 percent of business meals, tax-exempt interest, depreciation differences and the dividends received deduction of 50, 65 or 100 percent depending on ownership. Net operating losses arising after 2017 carry forward indefinitely and offset up to 80 percent of taxable income. Earnings and profits determine whether distributions are dividends. Corporate formation under section 351 is tax-free when transferors of property control at least 80 percent after the exchange. Trusts and estates, exempt organizations and the federal gift and estate taxes also appear, mostly at the understanding level; know the 2026 annual gift exclusion of 19,000 dollars and that the 2025 act set the estate and gift exclusion at 15 million dollars, as ACCT-351 recorded.

Other taxes and credits on the exam

Several taxes beyond the regular income tax appear regularly in REG questions. The net investment income tax is 3.8 percent of the lesser of net investment income and the excess of modified AGI over 200,000 dollars for single filers or 250,000 dollars for married couples filing jointly; these thresholds are not indexed for inflation. The additional Medicare tax of 0.9 percent applies to wages and self-employment income above the same thresholds. The alternative minimum tax applies when tentative minimum tax, computed on a broader base with an exemption, exceeds regular tax; the 2025 act made the higher exemption amounts permanent but changed the phase-out, so check the testable figures. The kiddie tax taxes a child's unearned income above a threshold at the parents' rate. On the credit side, distinguish refundable credits, such as the earned income credit and part of the child tax credit, from nonrefundable credits, which can reduce tax only to zero, and know which credits phase out with income. A question that gives you a high-income taxpayer with investment income is usually testing the net investment income tax; one with large incentive stock option exercises is usually testing the alternative minimum tax.