What Is A Pass Through Entity?
A pass-through entity (also known as flow-through entity) is a business structure in which business income is treated as personal income of the owners. It is used to avoid double taxation, when business income is subject to corporate tax and then to the owner’s personal income. The tax liability is thereby passed onto the owners and the business income is only subject to individual income tax.
How Do Pass Through Entities Work?
Income generated by pass-through entities is passed directly to the owners of the entity and taxed as personal income, effectively making it exempt from corporate income tax. This allows business owners to pay individual income taxes as opposed to both corporate income taxes and dividend taxes. When it’s time to file taxes, each partner’s share of the company's earnings is reported on a Schedule K-1 form.
Types of Pass Through Entities
Pass-through entities can be set up in multiple ways. Common types of pass-through entities include:
Example of Pass Through Entity Tax Return
To demonstrate the potential tax benefits offered by a pass-through entity, we can compare the taxes owed by a pass-through entity vs a C-corp.
Example 1
Company ABC – a New York-based pass-through entity that is equally owned by two individuals – earned $200,000 in revenue. The owners of the company would report the following results:
| Revenue | $200,000 |
|---|---|
| Expenses | -50,000 |
| Earnings Before Interest and Taxes (EBIT) | $150,000 |
| Interest Paid | -$50,000 |
| Earnings Before Taxes (EBT) | $100,000 |
| Net Income Available to Owners | $100,000 |
| Total Taxable Income | $100,000 |
Since the company is equally owned by two individuals, the owners would report their share of the company’s net income on their personal tax returns.
Since there are two owners, each owner is responsible for 50% of the net income ($100,000 / 2 = $50,000 each). Ignoring social security and medicare payments and assuming that they don't have other income, withholdings or retirement contributions – we can use an income tax calculator to determine that each individual would owe $4,342 in federal income tax.
Multiplied by two, we can conclude that the company’s earnings generate $8,684 in federal income tax liability, which is an effective tax rate of 8.68%.
If the company were a C-Corp, it would owe 21% in federal taxes on $100,000 of earnings, or $21,000. This doesn't include the effects of double taxation that would occur if the company’s earnings were distributed to the owners. In this situation, the company’s earnings would be taxed at the corporate level and any distributions would be taxed as personal income, which is called double taxation.
In this situation, the business’ earnings would generate less federal income tax liability if it were a pass-through entity than if it were taxed as a C-corp.
Example 2
Company XYZ – a New York-based pass-through entity that is equally owned by two individuals – earned $1,000,000 in revenue. The owners of the company would report the following results:
| Revenue | $1,000,000 |
|---|---|
| Expenses | -400,000 |
| Earnings Before Interest and Taxes (EBIT) | 600,000 |
| Interest Paid | -100,000 |
| Earnings Before Taxes (EBT) | 500,000 |
| Net Income Available to Owners | 500,000 |
| Total Taxable Income | $500,000 |
Since the company is equally owned by two individuals, each of the owners would report 50% ($250,000) of the company’s net income on their personal tax returns. Ignoring social security and medicare payments and assuming that they don't have other income, withholdings or retirement contributions, we can use an income tax calculator to determine that each individual would owe $58,424 in federal income tax.
Multiplied by two, we can conclude that the company’s income generates $116,848 in federal income tax liability, which is an effective tax rate of 23.37%.
If the company were a C-Corp, it would owe 21% in federal taxes on $500,000 of earnings, which would be $105,000.
In this situation, the company would pay less federal income tax on its earnings as a C-corporation than its owners pay as individual taxpayers. However, it’s important to note that dividends paid to owners would be taxed as personal income, which could increase the overall federal tax liability due to double taxation.
How Can You Tell if Your Business is a Pass Through Entity?
Sole proprietorships, partnerships, LLCs, and S-corps are automatically considered pass-through entities.
If you start a business alone or with a partner, the business is automatically considered a sole proprietorship or partnership unless you file the paperwork to register and set up an LLC or S-corp. Unless you convert the business to a C-corp (or opt to be taxed as a C-corp), you are automatically a pass-through entity.
The Pros and Cons of Pass Through Entities
While pass-through entities account for the majority of US businesses, they are one of many business structure options. It’s best to explore their pros and cons of pass-through entities to better understand what they have to offer.
Pros of Pass Through Entities
Many small businesses prefer entities over C-Corps. There are a few reasons why:
Tax Reductions
By treating business as personal income, pass-through entities allow businesses to avoid double taxation.
Easy Setup
Some pass-through entities (such as sole proprietorships and partnerships) require very few fees and registrations, making them very easy to set up.
Equitable Tax Structure
By treating business income as personal income, owners in higher tax brackets will bear a larger portion of the tax burden.
Tax Deductions
Under the Tax Cuts and Jobs ACT (TCJA) that was introduced in 2018, pass-through entities can potentially deduct up to 20% of their Qualified Business Income (QBI) income.
Deductible Losses
Owners of a pass-through entity can deduct losses incurred by their business in order to reduce their personal taxable income. However, there are limitations.
Cons of Pass Through Entities
Pass-through entities are not always the right choice for every business. Here are some reasons why a pass-through entity might not be a great fit:
Stock Limitations
S-corps are the only type of pass-through entity that allows for the issuance of stock. They are limited to 100 shareholders and one type of stock, which could make it more difficult to raise money from investors.
Difficult to Deduct Charitable Contributions
Unlike C-corps – which can deduct charitable contributions as business expenses – pass-through entities cannot. However, owners may be able to deduct charitable contributions on their personal tax returns, but only if they opt for itemized deductions.
Potentially Higher Tax Rates
Prior to the Tax Cuts and Jobs Act, the federal corporate tax rate was 35% regardless of income. This has since been lowered to around 20% (varies year-by-year). Personal income tax rates (which apply to pass-through entities) can be as high as 37%, depending on income. Additionally, owners of pass-through entities may also be responsible for self-employment taxes, along with state and local taxes.
Tax on Fringe Benefits
Fringe benefits (e.g. health insurance, stock options, company vehicles) are tax-deductible for C-corps and tax-free to the employees receiving them. Pass-through entities do not have this advantage, although there are some exceptions for health insurance, so fringe benefits may be subject to taxation.
Tax on Income Not Received
Owners of pass-through entities must pay tax on business income even if the money remains in the business bank account (instead of being distributed to the owners).
Why Pass-Through Entities Are Important
95% of US businesses are structured as pass-through entities, while only around 5% are structured as C-corps. Pass-through entities can pay lower taxes than C-corporations and can be structured in a number of ways, giving businesses flexibility in the way they operate.
