What Are Pass-Through Entities?
Pass-through entities are businesses that aren't subject to corporate income taxes. Also known as a flow-through entity or a pass-thru entity, this type of business structure allows profits to go directly to the owners or members who pay individual income taxes on any revenue. These businesses effectively avoid double taxation, or taxing both corporate income and individual income.
In 48 states, pass-through entities account for the majority of the private-sector workforce, according to the Tax Foundation. These businesses also account for about 40% of private-sector payroll. Pass-through entities are particularly common in the service industry, where they're responsible for over 70% of employment in arts, entertainment, and food service and 60% of employment in utilities, construction, transportation, information, education, and health care.
How Do Taxes Work for a Pass-Through Entity?
Although the pass-through entity definition states that these companies don't pay income taxes, they often have to file federal tax returns. These returns state the company's income and indicate how it flows through to the company's partners. Then each partner files a Schedule C, Schedule E, or Schedule K-1 to report their income from the business and pay the associated income taxes.
Since 1980, the increase in pass-through entities has contributed to a substantial decrease in corporate revenues , according to the Brookings Institute. If 1980 corporate tax levels remained in place today, business taxes would have generated about $100 billion per year.
From 2017 on, most pass-through entities have received additional tax breaks due to the Tax Cuts and Jobs Act. This act lets business owners and partners deduct 23% of their income , decreasing their individual rate and leading to savings. Because most individuals who claim pass-through income are high earners, these tax reforms offer significant savings for business owners. The top 1% of earners receive about 70% of partnership income, according to the Brookings Institute.
Do State Income Taxes Allow Pass-Through Income?
Although most states follow federal taxation rules for pass-through entities, some view these businesses differently. Connecticut, Louisiana, Oklahoma, Rhode Island, and Wisconsin all charge these companies at the entity level. To avoid double taxation, they give the company's partners a tax credit to apply to their individual income tax return.
No matter where you do business, it's important to confirm business structure and taxation rules before filing your return. Pay close attention to state tax reforms, as the current rules may change with limited notice.
How Do You Know If Your Company Is a Pass-Through Entity?
The vast majority of businesses in the United States are pass-through entities. That means there's a good chance that yours is, too. When you start a new business, it's automatically categorized as a sole proprietorship or a partnership and considered a pass-through entity. It ceases being a flow-through entity only if you incorporate and choose to be taxed as a C-corporation.
Flow-through entities have contributed an increasing share of business activity since 1986, according to the Tax Policy Center. Today, they represent over 50% of the total net income for businesses in the U.S.
Types of Pass-Through Entities
To define pass-through entity, it's helpful to understand the many types of businesses that use this structure. Because so many business structures serve as flow-through entities, it's easy to choose one of these options to minimize your corporate tax burden:
- Sole proprietorship: Unlike other flow-through entities, businesses with single owners don't have to file separate income tax forms. Instead, the owner reports relevant income on Schedule C of their individual tax return. If you have a sole proprietorship, your net income may also be subject to payroll taxes.
- Partnership: Both general and limited partnerships have one or more owners and file a Form 1065 to report entity-level revenue. Each owner has to report their share of this revenue on Schedule E of their individual tax return. General partners typically have to pay payroll tax on their net income, but limited partners owe this tax on guaranteed payments only.
- Limited liability company (LLC): Whether you run a single- or multiple-member LLC, you have a few taxation options. You can choose for your business to be taxed as a partnership, which requires filing an entity-level Form 1065 and an individual Schedule E. Alternatively, you can choose for your company to be taxed as a corporation, which means your business is not considered a pass-through entity.
- S-corporation: With this business structure, your company gains pass-through corporation status. As an S-corporation, you have to file an entity-level Form 1120S, which allows profits to flow to shareholders, who report their income on an individual Schedule E. As a pass-through corporation, this type of business is subject to some additional restrictions. S-corporation owners have to receive reasonable compensation, on which they owe Federal Insurance Contributions Act (FICA) taxes.
In most cases , flow-through entities are smaller than C-corporations. However, not all pass-through entities are small businesses, according to the Tax Foundation. Altogether, about 72% of these entities have fewer than 100 employees, about 34% of which reflect self-employment. The remaining 28% includes companies with over 100 employees, and 16% of them are big businesses with over 500 employees.
Pros of Pass-Through Entities
If you're considering setting up a flow-through business, you could experience some significant perks. Some of the biggest benefits of this business structure include:
- Single taxation: Pass-through entities avoid double taxation by levying taxes on individuals only. As a result, the business and its owners or members can recover significant savings.
- Increased tax deductions: Tax reforms allow pass-through entities to deduct up to 20% of their income. These deductions can also lead to substantial savings.
- Opportunities for deductible losses: If pass-through entities incur losses, they flow through to the individual. Business owners can deduct these losses and reduce their own personal liabilities.
- More equitable taxation: For flow-through entities, all corporate income passes to the owners or members. Those in higher tax brackets naturally pay a higher percentage, which contributes to a more equitable burden.
- Straightforward setup: In addition to the many tax-related benefits, owners of pass-through entities also have an easier time setting up their businesses. Unlike C-corporations, which can be highly complex, sole proprietorships and partnerships require minimal paperwork and fees.
Cons of Pass-Through Entities
Although flow-through entities offer a wide range of benefits, they also have some potential drawbacks. Some of the most common downsides of pass-through entities include:
- Higher tax rates: Since 2018, the corporate tax rate has hovered around 20%, while the individual tax rate can be much higher, depending on income brackets. If your income flows through an LLC or a partnership, you could pay much higher tax rates.
- Fringe benefit taxes: C-corporations can deduct the cost of fringe benefits, while their employees don't have to pay taxes on them at all. In contrast, pass-through entities generally do.
- Taxes on income not received: Because all income from pass-through entities flows to the business partners, even if they didn't receive it, they may pay tax on income they didn't get yet. In contrast, C-corporations often have the ability to defer paying taxes on their share.
- Limitations on stocks: S-corporations benefit from a corporate structure and pass-through entity status, yet they face severe limitations on stocks. They can have no more than 100 shareholders, and they can only issue one type of stock. As a result, they may struggle to raise funds.
Whether you need advice on your business structure or you need assistance with your corporate filing, the ContractsCounsel team is here to help. Get a free proposal and take the first step toward forming your business today.
