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What Is A Pass Through Entity
A pass through entity is a type of legal entity where the business profits and losses are “passed through” directly to the business owners.
In other words, the business owners will declare the company’s revenues and expenses on their personal income tax return.
The end result is that the business entity does not directly pay taxes to the tax authorities, rather it’s the business owners that pay taxes.
The main types of legal entities that are pass through in nature are limited liability companies, S-Corporations, partnerships, and sole proprietorships.
Keep reading as I will tell you how pass through entities work and provide you with other useful information on this type of business entity.
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Why Is A Pass Through Entity Important
Pass through entities represent a significant portion of businesses in the United States.
In fact, approximately 95% of businesses in the United States are structured as pass through entities which include sole proprietorships, partnerships, LLCs, and S-Corporations.
Approximately 5% of businesses are structured as C-Corporations where the business and business owners pay their taxes separately.
Pass through entities allow business owners to reduce their tax liability.
By passing business revenues, expenses, gains, and losses to the business owner, a small business owner can avoid double taxation and end up with more money in his or her pocket.
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How Pass Through Entities Work
A pass through entity is a type of legal entity where business revenues are passed through the entity to the business owner.
This means that the business owner will be responsible to pay taxes on the income earned by the business.
When a business is operated through an entity that is not a flow through entity, the business revenues are taxed in the hands of the corporation or legal entity.
The business owners will not be taxed on the company’s revenues and expenses unless they are paid dividends or receive a distribution.
Also, individuals operating a business as a pass through entity will pay taxes based on the tax rates applicable to ordinary income.
On the flip side, if the company loses money, the business owner will be able to report the loss on his or her income tax.
For instance, if a pass through entity generates $1,000,000 in revenues and has $800,000 in expenses, the revenues and expenses will be declared by the business owner on his or her income tax.
If the entity was not a pass through entity, the company would have declared the revenues and expenses directly and be taxed on the net income of $200,000.
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Pass Through Entity Advantages
There are many advantages to operating a business as a pass through entity.
One key advantage is that business owners can avoid double taxation.
Double taxation is when the same dollar is taxed in the hands of a corporate entity and the business owner (thus, taxed twice).
Another important advantage is that some pass through entities are generally easier to set up and manage.
For instance, there’s not much formality in operating a business as a sole proprietor or partnership as compared to running a corporation.
Another benefit of operating a business as a pass through entity is that business owners can deduct losses incurred by the business on their personal income taxes.
This means that the business owner can reduce his or her tax liability to the extent the business incurred a loss.
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Pass Through Entity Disadvantages
Although pass through entities offer many advantages, there are also certain disadvantages that you should consider.
The most notable disadvantage is that you may have to pay taxes on income that you did not actually receive.
For instance, if the pass through entity generated profits that it fully reinvested back into the business, the business owners will still need to report the profits and pay taxes.
Another disadvantage in operating a flow through entity is that some of the entities do not provide limited personal liability protection.
Sole proprietorships and general partnerships leave the business owners exposed to personal liability.
Another drawback is that you must ensure that you operate the pass through entity properly and comply with the requirements allowing it to give you the tax benefits.
If you are not careful, you may end up having to pay more taxes.
For instance, if individuals have a higher tax rate than corporations, then you may end up having to pay more taxes on the business revenues.
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Types of Pass Through Entities
There are different types of entities that you can operate allowing you to take advantage of pass through taxation.
The main pass through entities are: s-corporations, limited liability companies, income trusts, limited partnerships, limited liability partnerships, general partnerships, and sole proprietorships.
An S-Corporation is essentially a corporation that is taxed under Subchapter S of the Internal Revenue Code.
The S-Corp shareholders are required to pay themselves a reasonable compensation and pay Social Security Tax but will not have to pay self-employment taxes on their profits.
A limited liability company can be taxed as a pass through entity or a corporation depending on the choices made by the business owner.
An LLC is a highly flexible entity that provides the same protections as corporations but the tax benefits of partnerships.
Partnerships and sole proprietorships are taxed as flow through entities where the business owners will report the business income on their personal income tax.
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Pass Through Entity FAQ
What does “pass-through entity” mean?
A pass-through entity refers to a business that does not pay taxes at the entity level.
Any income earned by the business is passed to the business owners who pay personal income taxes on their share of the business revenues.
What is not a pass-through entity?
A C-corporation is not a pass-through entity.
You can also have an LLC taxed like a corporation as it’s a type of business entity that allows business owners elected to be taxed like a partnership or a corporation.
What is an example of a pass-through entity tax return?
Let’s assume that Company A is a pass-through entity that has earned $1,000,000 in revenues and has $800,000 in expenses.
The company’s net income is $200,000.
Since the company is a pass-through entity, Mary who is the business owner will have to report $200,000 on her personal income taxes.
If the company was not a pass-through entity, then Company A would have had to pay corporate taxes on the $200,000.
Then, using after-tax money, the company would have paid dividends or distribution to the business owners who would then pay personal income tax on their share of the profits.
Takeaways
So there you have it folks!
What is a pass-through entity?
In a nutshell, a pass-through entity is a type of business structure where business income is taxed in the hands of the business owners like personal income.
One important reason why many businesses in the US operate as pass-through entities is that they avoid double taxation where business income is taxed in the corporation’s hands once and in the hands of the shareholders a second time.
When income is generated by a pass-through entity, it is directly passed to the business owner.
This means that the pass-through entity is exempt from corporate taxes and the business owners will pay taxes on their personal income tax.
Sole proprietorships, partnerships, LLCs, and S Corporations are considered pass-through entities.
Now that you know what a pass-through entity is and how it works, good luck with your research!
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