Feb 9, 2023 | Startup and Launch

What Is a Pass-Through Entity?

A pass-through entity refers to a business that does not pay income tax of its own. Its income, losses, credits, and deductions “pass-through” to each business owner’s personal tax return, where its profits are taxed according to each owner’s individual income tax rate. Sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies, and S Corporations are all pass-through entities. Corporations, and limited liability companies that elect to be taxed as a corporation, are not pass-through entities.

Many entrepreneurs choose pass-through business structures for various reasons, including their relative tax-filing ease compared to C Corporations.

In this article, I’ll cover details to help you get a better understanding of pass-through entities:

  • How business owners get paid
  • Tax treatment (income and self-employment taxes)
  • 2017 Tax Cuts and Jobs Act impact on pass-through entities
  • Advantages and disadvantages of operating as a pass-through entity

How Pass-through Entities Pay Their Owners

Before we talk about income and self-employment taxes, I think it’s important to discuss how business owners get paid when operating a pass-through entity.

Generally, with sole proprietorships, LLCs, and partnerships, owners cannot be considered employees of their company, nor can they receive compensation in the form of wages and salaries. Instead, they get paid via “owner’s draws.” An owner’s draw means that they take money out of their share of the company’s profits—usually either by writing themselves a business check or transferring funds (if the bank allows it) from the business to their personal account.

An exception is LLCs that elect for S Corporation tax treatment. S Corps must put owners who work in the business on payroll and pay them a reasonable wage or salary for the work they perform.

Either way, all of a pass-through business’s profits and losses are ultimately those of its owners.

Pass-Through Entity Tax Treatment

Income Tax

Taxes of a pass-through business entity flow through to the owners’ individual tax returns. Business profits are taxed at the individual owner’s personal tax rate rather than the corporate tax rate. Will this be advantageous overall? It depends. It might be—if the owner’s individual tax rates are lower than the corporate tax rate. But many factors can come into play (such as state tax laws where a business is located), so it’s best to enlist the expertise of an accountant or tax professional who can assess the situation and offer insight.

Below, I’ve shared some general information about how federal income taxes are handled for the various pass-through entity types.

  • Sole Proprietorships – A business and its owner are not separate tax-paying entities in a sole proprietorship. The income tax filing for the business gets calculated on Schedule C of the owner’s personal tax return, with the net income or loss passed through to Schedule 1 of IRS Form 1040.
  • Single-Member LLCs – Income tax for single-member LLCs (an LLC with one owner) is handled the same way as a sole proprietorship. Business income and losses flow through to the owner’s personal income tax return.
  • Partnerships – In a partnership, the business’s income or loss is divided among the owners (“partners”) according to their distributive share percentage described in the company’s partnership agreement. The partnership reports its income and losses on a partnership return (IRS Form 1065). Also, each partner receives a Schedule K-1 that shows their share of the business profits. Each partner must then include information in Schedule E of their personal tax return.
  • Multi-Member LLCs – The IRS treats multi-member LLCs the same as partnerships; owners are taxed as partners. They receive a Schedule K-1 from the LLC based on their share of the business’s profits. Then they must report that information in Schedule E of their Form 1040.
  • S Corporations – An S Corporation’s income taxes pass through to its owners, but tax filing requirements depend on the underlying business entity. The S Corp is not a type of business entity but a special tax election that eligible LLCs and C Corporations may request from the IRS.  These resources on the IRS website provide more information: LLC Filing as a Corporation or Partnership and About Form 1120-S, U.S. Income Tax Return for an S Corporation.

Self-Employment Taxes

The owners of pass-through entities are subject to self-employment taxes under SECA (the Self-Employment Contributions Act of 1954). Self-employment taxes include Social Security and Medicare taxes. Self-employed individuals must pay the entire 12.4% Social Security tax and 2.9% Medicare tax, which totals 15.3% to the federal government. Typically, they must pay these in quarterly installments with their estimated income taxes.

People employed by other businesses must contribute to Social Security and Medicare, too. But it’s handled differently for employed individuals; half of those taxes are paid by the employer, and the other half are withheld from employees’ paychecks and remitted by the employer to the federal government.

In S Corporations, the self-employment tax burden on the business owners is lessened because individuals only pay SECA tax on their wages and salaries from the business. The individuals’ “employee income” from their wages is subject to 50% of the Social Security and Medicare taxes and withheld from their paychecks. The S Corp pays the other 50% of those taxes. The remaining business profits paid as distributions to the S Corporation owners are subject to income tax but not self-employment taxes. Be aware that entrepreneurs must take care to pay themselves a reasonable salary. If they try to game the system by paying themselves a meager wage and take most of their compensation via distributions to avoid paying self-employment taxes, the IRS may become suspicious and initiate an audit. Who needs that hassle and headache?

The TCJA and Pass-Through Entities

The Tax Cuts and Jobs Act (TCJA), which was passed into law at the end of 2017, created tax reforms that affect pass-through entities. Pass-through entities may claim a 20% deduction of their share of Qualified Business Income (QBI) before paying federal income taxes. There are limitations to what can be calculated in the deduction and how much of a deduction is allowed. Here are some highlights:

  • The deduction must be equal to 20% of the QBI earned from the business.
  • Not all business income is considered to be QBI, so the deduction amount may not be as significant as one might hope for.
  • The deduction is restricted to the lesser of 20% of the business’s QBI or 50% of the total W-2 wages paid by the business.
  • The 20% deduction may not apply for businesses where “the principal asset is the reputation or skill of one or more of its employees or owners” if their income reaches a particular threshold. That includes services in the fields of health, law, accounting, performing arts, consulting, athletics, financial services, and others.
  • Other limitations apply to pass-through entities other than service providers if their taxable income exceeds specific thresholds.
  • Other restrictions and nuances also exist, so it’s helpful to get professional tax assistance when calculating the deduction and preparing tax forms.

Potential Advantages

1. Simple to Form

Sole proprietors and general partnerships (usually) require no entity registration paperwork with the state. These structures are assumed as soon as someone begins conducting business. If business owners wish to operate their company under a name other than one that includes their legal personal name, the state (or county) may require filing a DBA (a.k.a. fictitious name filing). A business with a single owner is by default considered a sole proprietorship. A company with multiple owners is by default considered a general partnership.

Forming an LLC requires filing Articles of Organization with the state. If an LLC wants to be treated as an S Corp for tax purposes, it must file IRS Form 2553.

2. Minimal Business Compliance Formalities

Pass-through businesses generally have less government oversight and fewer ongoing compliance requirements than corporations. C Corporations must appoint a board of directors, have bylaws, and hold annual shareholder meetings and board of directors meetings. They also may have some state reporting requirements that pass-through entities do not.

Note that LLCs (including LLCs that choose to be taxed as an S Corporation) have compliance requirements that sole props and partnerships do not. Some states may require that LLCs hold annual member meetings and record minutes from those events. Although states typically don’t demand member meetings, an LLC may need to hold them and record minutes if their LLC operating agreement requires it.

Like all types of businesses, pass-through entities—including sole proprietorships and partnerships— must make sure they obtain the required licenses and permits to operate legally (local, state, and federal—depending on the type of business and its location). They must also report and pay all tax obligations on time and follow any other rules and regulations that apply to them.

3. Not Subject to the Double Taxation That C Corporations Face

A C Corporation pays tax on its profits at the corporate rate. Its shareholders also pay personal taxes on any corporate profits that they receive as dividends. Those dividends are not tax-deductible for the corporation. Because a C Corporation and its owners both pay tax on that dividend income, it’s referred to as double taxation.

Pass-through entities have all income flowing through to their owners. They do not pay tax as a business entity and therefore avoid the double tax hit corporations undergo.

Potential Disadvantages

1. Might Not be Financially Beneficial for the Business’s Owners

Business owners may find that they fall into a higher individual tax bracket with all profits passing through to their individual income tax returns. Depending on the circumstances, this might result in paying more tax overall than they would if they had incorporated the business.

2. Might Bear a Heavy Self-employment Tax Burden

Owners of sole proprietorships, partnerships, and LLCs may find that their self-employment tax burden is prohibitive. Remember, they pay it on all of the business’s profits. In contrast, S Corporation owners only pay self-employment taxes on the wages and salaries they get paid.

3. Sole Proprietorships and General Partnerships are Not Protected from Business Liabilities

Business owners are not only the same tax-paying entity as their businesses, but they are also the same legal entity. With no legal separation between owners and the business, if someone were to sue the company, the owners’ personal assets (home, retirement funds, vehicles, etc.) are at risk.

The LLC and S Corp offer their owners limited liability protection. Under most circumstances, their owners are personally protected from debts and legal actions against their companies. C Corporations provide the greatest level of personal liability protection for business owners and certain stakeholders.

4. May Have a More Difficult Time Attracting Investors

Some investors are only willing to invest in businesses that have incorporated. This may limit pass-through companies’ growth potential as they face challenges in getting the funds needed to expand and evolve.

Should You Utilize a Pass-Through Entity?

Could operating a pass-through business or incorporating be the right choice for you? There’s much to consider! Anyone who is starting a business should research the various entity types carefully and speak with licensed accounting, legal, and tax professionals for expert guidance before deciding on a business entity type.

Fortunately, after you’ve decided on the right business structure for your business, CorpNet is here to help with all of your necessary business filings. From DBAs for sole proprietorships to Articles of Organization for LLCs to preparing S Corporation election forms and more, we will help you get your business off to a successful, compliant start. And we’ll help you keep it that way no matter where you are in the United States.

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<a href=index-949.html target="_self">Nellie Akalp</a>

Nellie Akalp

Nellie Akalp is an entrepreneur, small business expert, speaker, and mother of four amazing kids. As CEO of CorpNet.com, she has helped more than half a million entrepreneurs launch their businesses. Akalp is nationally recognized as one of the most prominent experts on small business legal matters, contributing frequently to outlets like Entrepreneur, Forbes, Huffington Post, Mashable, and Fox Small Business. A passionate entrepreneur herself, Akalp is committed to helping others take the reigns and dive into small business ownership. Through her public speaking, media appearances, and frequent blogging, she has developed a strong following within the small business community and has been honored as a Small Business Influencer Champion three years in a row.
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