When you're starting a new small business, one of the most important things to consider is its business structure. Chances are, your new business will operate as a pass-through entity. While the term may seem esoteric, pass-through entities are relatively straightforward. Read on to learn what a pass-through entity is, how a pass-through entity works and what to know about the different types of pass-through entities.
What is a pass-through entity?
According to the Tax Policy Center, a pass-through entity is any business in which "profits flow through to owners or members and are taxed under the individual income tax." This separates most businesses from corporations, specifically C corporations, since those entities are taxed in a completely different manner.
How do pass-through entities work?
Pass-through entities prevent the owners of a business from being double taxed (on both corporate and personal income) for federal income tax purposes.
"The tax liability is simply passed on to the owners, and the business income is only subject to individual income tax of that particular owner," said Bryce Bowman, a chartered financial analyst and founder of People First Planning.
Because the business's income directly impacts an owner's personal federal income tax return, the company is exempted from corporate taxes. Depending on how the business is structured, taxes are reported through specific IRS forms. For example, members of a partnership and shareholders within an S-Corporation file IRS Form Schedule K-1 to report an owner's tax obligations, while self-employed individuals report their earnings through their personal 1040 with an attached Schedule C form. As such, it's important to make sure you use the correct forms when filing.
Types of pass-through entities
Pass-through entities are the most common type of business in America. Approximately 95% of U.S. businesses are structured as pass-through entities, according to data from Brookings. A major reason for their popularity stems from the fact that it provides some protection to the business's ownership, according to Mark Puzdrak, a CPA at Puzdrak CPA LLC,
"Forming a pass-through entity is relatively simple and most business owners like the protection the structure provides for legal purposes," he said. "One of the biggest factors that determine the type of pass-through entity are the tax savings."
Because there are multiple types of pass-through entities, you'll need to consider the pros and cons of each before deciding which structure is right for you.
Here are some types of pass-through entities:
If you're an individual business owner, your company is already a sole proprietorship. Once you report self-employed business income with the IRS and don't set a different type of business structure, the agency will automatically classify your business as a sole proprietorship.
"You're automatically a sole proprietor once you report business income on your personal tax return," Bowman said. "This type of entity has only one owner and is a simplified business type suitable for contractors or freelancers."
In a sole proprietorship, the business owner and the business itself are one and the same. For tax filing purposes, the owner of a sole proprietorship files an IRS Form Schedule C with their 1040. That lack of distinction between you and your business also means you will be held personally liable for any legal problems. This is a major risk that can put your personal assets at risk.
Limited liability company (LLC)
In contrast to sole proprietorships, limited liability companies keep their owners, known as members, legally separate from the business. As a result, the owner is protected from any personal liability when it comes to the company's debts or legal issues.
"If, in the course of business, you mistakenly cause harm to someone else, any legal claim can only take the assets of your business," Bowman said. Under an LLC, "your personal assets are still shielded from lawsuits."
To form an multimember LLC, you should start by making a formal business partnership agreement outlining how the business is organized and each member's responsibilities within the LLC. The flexibility and protection provided by an LLC also extends to how the business pays taxes, since it can be taxed as any of the other pass-through business structures. There is no cap on the number of members an LLC can have, unlike with S corporations, which are limited to 100 shareholders.
A partnership is a business structure in which two or more individuals team up to create a new venture. Under this kind of agreement, the partners work together to manage and conduct the business in a bid to share in the profits, responsibilities and liabilities. There are numerous types of partnerships to consider. Depending on the type of partnership, some individuals may have a bigger stake in the business than others. When filing their taxes for a taxable year, each partner completes IRS Form 1065.
Unlike other pass-through entities, an S corporation isn't a structure but rather an elected tax status. According to the IRS, an S corporation is a corporation that "elects to pass corporate income tax, losses, deductions and credits through to their shareholders for federal tax purposes." To become an S corp, a business must first start out as either an LLC or a C corporation.
Owners under an S corp, referred to as shareholders, are taxed as a partnership that shields those owners from getting taxed twice. Additionally, these owners are considered employees of the business and are required to pay themselves a salary. All of the company's profits, losses, deductions and credits are filed at the shareholder level via IRS Form 1120-S.
Pros and cons of pass-through entities
Though there are different pros and cons of each kind of pass-through entity, there are some general benefits and drawbacks you should consider.
- Some pass-through entities are easy to start. For example, a sole proprietorship is an automatic designation by the IRS.
- Deductions apply to business income earned. According to Carol Tompkins, a business development consultant at AccountsPortal, this kind of status can reduce the tax burden for each owner. "Furthermore, the owners of such businesses also have limited liability in these entities, which means their assets will not be sold to offset any debt obligations of the company," she said.
- Pass-through entities avoid double taxation. The biggest reason to start a pass-through entity is to avoid double taxation.
- You get a QBI deduction of 20%. Following the passage of the Tax Cuts and Jobs Act of 2017, pass-through entities can deduct up to 20% of their business's qualified business income (QBI) from their taxes.
- Pass-through entities may not be suitable for bigger organizations. If your company is already large or plans to scale up anytime soon, you may not be able to reap the benefits of being a pass-through entity. Tompkins said that organizations with a large number of investors or those that deal with a "high level of uncertainty" benefit less from being a pass-through entity.
"The level of uncertainty could expose the investor to personal tax liabilities that are unfunded by the business," she said.
- S corps have some inherent downsides. S corporations have some restrictions that may make it less appealing. One such downside is that shareholders are not allowed to deduct losses in excess of their investment in the company. The other issue is that if the company provides low compensation for shareholders, it may limit the contributions that shareholders can make to retirement plans.
- Charitable contributions are harder to deduct. Some types of pass-through entities limit deductions for charitable donations. Sole proprietorships and single member LLCs cannot deduct charitable contributions, since individuals can only deduct donations on their 1040 Schedule A while their business taxes are filed with a Schedule C. Partnerships and S-Corporations handle charitable donations by making each partner take a cut of the deduction on their own tax return, with the partnership's total contribution being limited to $250 unless it gets a written letter from the charity that "shows the amount of cash contributed, describes any property contributed, and gives an estimate of the value of any goods or services provided in return for the contribution," according to the IRS.