Pass-Through Entity: Definition & Overview

KEY TAKEAWAYS

• Pass-through entities include sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations.
• The main advantage of a pass-through entity is that it avoids double taxes on business income.
• Pass-through entities are also simpler to operate than C corporations.
• The main disadvantage of a pass-through entity is that the owners are liable for the debts and obligations of the business.

What is a Pass-Through Entity?

A pass-through entity is a type of business structure in which the business’ income is “passed through” to the owners or shareholders. And so, it isn’t subject to corporate income tax. This contrasts with a C corporation, which is subject to corporate income tax.

There are a few different types of pass-through entities. The most common are S corporations, limited liability companies (LLCs), and partnerships. Each type has its own rules and regulations governing how the business runs and how income gets taxed.

Pass-through entities are often chosen for their simplicity and flexibility. They also tend to be less expensive to set up and maintain than a C corporation. And because the owners are only taxed on their personal income, they may end up paying less in taxes.

How Do Pass-Through Entities Work?

A pass-through entity is usually a company that does not have any equity owners and does not have to pay corporate taxes. Instead, it distributes the income to the corporation owners, who report it on their personal tax returns. A partnership is a perfect example of a pass-through entity.

Partners in a given business file taxes based on their share of the profits, which they report on their 1040s. Each partner calculates income taxes, including deductions, credits, and so on. They also remit the appropriate share of income to the IRS.

Sales of partnership or LLC membership interests are not usually taxable to the selling partner or member. These are “pass-through” entities.

Types Of Pass-Through Entities

There are three main types of pass-through entities. They are S corporations, limited liability companies (LLCs), and partnerships.

S corporation: An S corporation is a type of small business corporation that’s taxed as flow-through entity level income. To qualify as an S corporation, the business must meet certain requirements set by the IRS.  For example, the business must have no more than 100 shareholders and can only have one class of stock.

LLC: A limited liability company (LLC) is a type of business structure that offers personal liability protection to its owners. LLCs can get taxed as either a pass-through entity or a C corporation. The tax treatment depends on how the LLC is set up and how many members it has.

Partnership: A partnership is a type of business structure in which two or more people share ownership. Partnerships can be either general partnerships, limited partnerships, or limited liability partnerships. Like LLCs, they can get taxed as either pass-through entities or C corporations.

When choosing the right type of flow-through entity for your business, it’s important to consider a few key factors. I.E., the size and structure of your business, the amount of liability protection you need, and how you want the business taxed.

S corporations may be good for businesses wanting liability protection but don’t want to be subject to corporate income tax.

LLCs may be a good choice for businesses that need flexibility in how they’re taxed and structured.

And partnerships may be a good choice for businesses owned by two or more people.

What Are The Importance Of Pass-Through Entities?

Pass-through entities are important in many ways. For one thing, they comprise the majority of businesses in the United States, so they are important from a sheer volume point of view.

Pass-through entities reduce the administrative burden on taxpayers. These entities keep taxes transparent and make accounting easier. Thus, they make it less burdensome for small businesses to maintain the necessary records.

What Are The Advantages Of Pass-Through Entities?

There are a few key advantages of pass-through entities:

Simplicity: Pass-through entities are often simpler to set up and maintain than C corporations. This is because they have fewer rules and regulations governing their operations.

Flexibility: Pass-throughs offer more flexibility than C corps in how they’re taxed and structured. For example, LLCs can choose to get taxed as either a pass-through entity or a C corporation.

Less Expensive: Pass-through entities tend to be less expensive to set up and maintain than C corporations. This is because they have fewer compliance requirements.

Lower Taxes: The owners of pass-through entities are only taxed on their personal income. This means they may end up paying less in taxes than the owners of a C corporation.

What Are The Disadvantages Of Pass-Through Entities?

There are also a few disadvantages of pass-through entities:

Personal liability: Owners are personally liable for the debts and obligations of the business. This is not the case for C corporations, which have limited liability protection.

Double taxation: C corporations are subject to corporate taxable income. This means the business itself pays taxes on profits. The shareholders then pay taxes on their dividends. This is double taxation.

Complexity: Pass-through entities can be more complex than C corporations. This is due to their flexibility in how they’re taxed and structured. For example, LLCs can choose to get taxed as either a flow-through entity or a C corporation.

Now that you understand the basics of pass-through entities, let’s take a closer look at each type.

Summary

A pass-through entity is a business structure in which income from the business “passes through” to the owners or shareholders. They then report that income on their personal income tax returns. This is in contrast to a C corporation, in which the business itself pays taxes on its profits.

There are several reasons why someone might choose to structure their business as a pass-through entity. It can save on taxes since the owners only pay taxes on their personal income, rather than the business’s profits. This can be a significant advantage for small businesses or businesses with high profit margins.

Another reason is that pass-through entities are simpler to set up and maintain than C corporations. They also tend to be more flexible. This lets owners make changes to the business structure without significant tax consequences.