Pass through entity
taxes

What is a pass-through entity? Definition and types to know

Company structure plays a major role in running a business, including how it’s taxed. You need to have your company structured a certain way to optimize your tax output, and a popular option is a pass-through entity. A pass-through entity allows you to avoid what’s known as double taxation on earnings. 

To understand the differences between business structures, it’s important to consider how a particular structure impacts your taxes as well as the overall pros and cons. 


What is a pass-through entity?

Pass-through entity. Why is it important?

A pass-through entity, also known as a flow-through entity, is a business that moves all income over to the owner(s) of the business. Instead of being taxed twice, the income is instead taxed at an individual’s tax rate instead of a corporate tax rate. 

Why are pass-through entities important?

Businesses are usually taxed for both corporate and individual taxes. No one likes to pay more taxes than absolutely necessary, and pass-through entities accomplish this by incurring only one tax: the individual tax. This allows for more income to be put into the business rather than going to taxes. 

How do pass-through entities work?

Traditionally, individuals have to pay taxes on their income and businesses have to pay taxes on their revenue. Pass-through entities bypass part of this process. They allow all business revenue to pass to the individual as income and only get taxed as individual income. The business is then no longer responsible for paying corporate taxes. 

To better understand the process, see the taxation breakdowns below.

In a non-pass-through entity:

  • The business pays corporate taxes on its revenue
  • The business then pays its shareholders through dividends
  • Dividends are taxed with personal income taxes

In a pass-through entity:

  • The business pays no corporate tax
  • All revenue is passed directly to the owners
  • Owners pay personal income tax on that amount

Pass-through entity limitations

While there is no limit to how much you can earn within a pass-through entity, there is a limit to how much you may deduct in taxable income through the 20% rule. 

If you file as Single: You may deduct up to $164,900

If you’re Married Filing Jointly: You may deduct up to $329,800

Types of pass-through entities

What are the types of pass-through entities? LLC, S corporation, Partnership, Sole proprietorship

Types of pass-through entities include LLCs, S-corps, and partnerships. 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 business you run, one structure may benefit you more than another. Learn more through our guide on choosing a business structure.

LLC, S-corps, and partnerships

These three structures are commonly grouped together regarding their taxation processes since they are all pass-through entities that utilize Form 1065 and Schedule K-1 for tax filing. While LLCs, S-corps, and partnerships are all separate business structures, they all pass profits and losses directly to the owners. 

LLC

LLC owners are referred to as members, and they offer limited liability to the owners but are less susceptible to strict compliance requirements than a corporation.


  • This option is best for those wanting to forego the formalities and multitude of paperwork. LLCs are also allowed flexibility on how they will be taxed.

Example:

Assume, for example, that Bob owns a gift shop as an LLC. The gift shop profits pass through to Schedule C of Bob’s personal tax return (Form 1040).

The business profit on Schedule C is added to other income on Bob’s personal return, and that total goes into the tax calculation. 



S-corp

S-corp owners are described as shareholders. They issue up to a limited number of stock shares (100) and only in a single class.


  • This option is best for those who want the asset protection and ease of conversion that S-corps provide.


Example:

If Bob’s gift shop was set up as an S-corp, he would file Form 1120 as an information tax return. Still, he would pay no corporate income tax but the income would flow through to the owners and be reported on their personal income taxes.

Partnerships

Those involved in a partnership have ownership rights, which means there are multiple people who share the assets and liabilities of the partnership.


  • Partnerships are best suited for those who want access to a new market, want to block a competitor, or are looking for help in expansion.


Example:

If Bob’s gift shop was run as a partnership, he would file Form 1065 as an information tax return. Still, he would pay no corporate income tax but the income would flow through to the owners and be reported on their personal income taxes.

Ultimately, the profits generated by all of these businesses flow through to the owners.

Sole proprietorship

With a sole proprietorship, there is no separation between you and your business. This is the default business structure since it happens automatically unless you file for a different structure.


  • A sole proprietorship is best for those who don't mind being personally liable for any risks associated with their business.


Example:

As with an LLC, if Bob owns a gift shop as a sole proprietor, the gift shop profits pass through to Schedule C of Bob’s personal tax return (Form 1040).

The business profit on Schedule C is added to other income on Bob’s personal return, and that total goes into the tax calculation. 

Pass-through example

Using a pass-through entity as an example, let’s say that Bob files a joint tax return with his wife Sue. Bob’s gift shop business generates a net income of $50,000 for the year, and Sue receives a W-2 form with gross wages of $60,000 from her job. Bob and Sue also earn $2,000 in interest and dividend income. All of these amounts are included as income on Bob and Sue’s joint tax return.

Meaning that all of the income on their joint tax return is included and they don’t have to pay corporate taxes on anything.

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. 

 Pros

  • Avoid double taxation: The greatest benefit that a pass-through entity has to offer is avoiding corporate tax implications. As we discussed earlier, individuals are only responsible for their individual income taxes and not any that would be incurred through corporate taxes. 
  • Utilize a 20% tax deduction: Another great benefit is having a 20% tax deduction on income. This equates to reducing your taxable income by 20% in total. 
  • Divert income: This allows LLCs and S-corps to effectively choose their salary and only be taxed within the tax bracket they opt for. This means they only opt for a portion of their business income to be paid out as part of their income to avoid excess taxes.

 Cons

  • Tax on all income: If you as the business owner choose not to divert the income, then you could possibly be faced with being taxed on all of it—even the portions you didn’t directly receive, but that was put back into the business. 
  • Takes more work: Some pass-through entities (S-corps) take a lot more legwork at the beginning than an LLC, for example, but they also offer more benefits in the end, like the ability to receive cash dividends.

Pass-through entity FAQ

Pass-through entities can be a major benefit to their owners from several different views, including taxation and simplicity. To cover all of our bases, let’s look at some commonly asked questions below. 

Is a C-corp a pass-through entity?

 A C-corp is not a pass-through entity. C-corp earnings are taxed twice, while the profits of sole proprietors, S corporations, and partnerships are only taxed once.

What is a pass-through entity tax?

The pass-through entity tax (PTE tax) is the tax incurred on the state level for your pass-through entity. Each state has its own requirement. For example, the Maryland tax rate is 8%, while Illinois’ is 4.95%. 

What is a disregarded entity?

A disregarded entity is an entity that is separate from the owner. However, when it comes to taxes, the IRS ignores the separation and taxes disregarded entities on the owner's return. 


Managing your pass-through entity transactions

Pass-through entities are a valid option when considering structuring your business and how you will be taxed. Another important factor to consider for your pass-through entity is handling your pass-through business transactions.

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


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