What is a pass-through entity? How it works and types

Feeling lost in the tax maze? Pass-through entities are business structures that help make taxes simpler.

Company structure plays a major role in running a business, including the taxes you’ll pay. To understand the differences between business structures, consider how a particular structure impacts your taxes and the overall pros and cons.

A pass-through entity allows you to avoid double taxation on earnings—corporations pay income taxes on their profits, and shareholders pay taxes on dividends they receive.

No one likes to pay more taxes than necessary, and pass-through entities allow for more income to go into the business rather than going to taxes. Let’s look at how pass-through entities work and the different types you can pick from.

How do pass-through entities work?

Pass-through entities allow business income and tax liabilities to pass to the owner. You then pay taxes for income from pass-through entities at your personal tax rate. The business itself does not pay taxes. To better understand the process, here’s a breakdown of how taxation works for each. 

For a nonpass-through entity, like a C-corp:

• The business pays corporate taxes on its income 
• The business can pay shareholders through dividends
• But shareholders pay taxes on dividends 
• And the dividends are not tax deductible for the corporation

In a pass-through entity, like a sole proprietorship:

• The business pays no corporate tax
• All income passes to the owner’s tax return 
• Owners pay income taxes on the business income at their personal tax rate 

There is no limit to how much you can earn within a pass-through entity, but there is a taxable income limit for the Qualified Business Income (QBI) deduction, which is $364,200 for those married filing jointly and $182,100 for all others.

Pass-through entity examples

There are a few ways to set up a pass-through entity, and all accomplish the same purpose of avoiding double taxation. However, depending on the type of operation you run, one business structure may benefit you more than another. The types of pass-through entities include LLCs, S-corps, partnerships, and sole proprietorships.

While LLCs, S-corps, and partnerships are all separate business structures, they all pass profits and losses directly to the owners. 

LLC

LLCs provide owners (also known as members) limited liability. However, they are less susceptible to strict compliance requirements than a corporation. 

LLCs offer flexibility with taxation, where you can elect pass-through or corporation taxation. Note that the default taxation for single-member LLCs, a popular option for solopreneurs, is the same as sole proprietorships. 

For example, assume Bob owns a gift shop as an LLC. The gift shop’s profits and losses pass through to Bob’s personal tax return. Bob would list his LLC’s profits and losses on Schedule C, which he’ll attach to his 1040 form. 

S-corp

An S-corp is not a business entity type but a tax election that LLCs or corporations can make with the IRS. An S-corp’s income taxes flow through to its owners. 

For example, if Bob’s gift shop elects S-corp taxation he would file Form 1120-S as an information tax return. He would pay no corporate income tax, and the income would flow through to his personal tax return. 

Partnerships

With partnerships, you divide the business income among the owners. The partnership files an information return, Form 1065, and sends each partner a Schedule K-1. The K-1 will report each partner’s share of business profits. 

If Bob’s gift shop operates as a partnership, he would need to file Form 1065 as an information tax return. He would pay no corporate income tax, the income flowing through to the partners.

Note that the IRS treats multimember LLCs like partnerships for tax purposes. 

Sole proprietorship

With a sole proprietorship, there is no separation between you and your business. This is the default business structure unless you file for a different one. A sole proprietorship is best for individuals who need simplicity and don't mind being personally liable for any risks. 

For example, if Bob owns a gift shop as a sole proprietor, he would report the profits and losses on Schedule C of his personal tax return. Bob would add the business profit from Schedule C to his other income and then calculate the income tax at his personal tax rate.

Pros and cons of pass-through entities

While it’s true that pass-through entities may look like an easy choice when selecting a business structure, there are a few things to consider before making a decision. 

To start, here are three key advantages of a pass-through entity:

• Avoids double taxation: The major benefit is these entities avoid double taxation, where dividends are not tax deductible. However, individuals receiving income from pass-through entities only pay taxes once. 
• Allows for a 20% tax deduction: Operating your business as a pass-through entity allows you to take the 20% QBI deduction via Section 199A. 
• Easy to form: Some pass-through entities, like sole proprietorships, do not require registration paperwork. You can start an LLC by filing articles of organization with your state. 

However, pass-through entities also come with disadvantages: 

• Pay taxes on all income: Owners of pass-through entities pay taxes on all income—even the portions that went straight back into the business. 
• More liability: Business owners of some pass-through entities may lack legal separation between owners and the business. 
• More difficult to attract investors: Many investors will only invest in a corporation structure, limiting the capital-raising options that pass-through entities have. 

The advantages and disadvantages of pass-through entities are a great starting point for figuring out if one of the structures works for you. However, if you need personalized guidance, consider consulting a tax professional. 

Find peace of mind come tax time

Pass-through entities are a viable option when structuring your business, and how you handle business transactions is important to its success. 

Consider using accounting software to separate and organize your business transactions. Staying up to date throughout the year can save you hours of hassle during tax season—leaving you with more time to focus on running and growing your business.

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