What It Is:
A pass-through entity is a special business structure that is used to reduce the effects of double taxation.
How It Works/Example:
Company XYZ is a pass-through entity. It files a tax return that looks like this:
Earnings Before Interest & Taxes (EBIT) 500,000
Interest Paid (100,000)
Earnings Before Taxes (EBT) 400,000
Net Income Available to Owners 400,000
XYZ has two owners, Jane and Bill, who each own 50% of the company. XYZ sends both Jane and Bill an IRS Schedule K-1 that reports their portions of XYZ's pass-through income. Jane and Bill each file their own tax return with $200,000 reported as income. It is important to note that Company XYZ allocates the income to Jane and Bill regardless of whether the $400,000 in Net Income is actually distributed.
Losses are also passed-through to owners, but the total deductible amount available is limited to the original investment amount.
Why It Matters:
Pass-through income can make for a confusing tax situation, depending on the complexity of company operations. Furthermore, sometimes pass-through income is not actually distributed to shareholders, leaving the owners with a tax burden but no cash with which to pay it.
For example, assume that Jane's tax burden ends up being 20% of $200,000 for tax year 2009. She owes the IRS $40,000, but XYZ did not make a distribution in 2009, and there is a possibility that it will not make a distribution in 2010, either. Jane is now responsible for taxes owed on income that she did not actually receive.