Pass-through entities are structured entities offering business owners a favorable tax rate while still protecting the owner or members from personal liability.
What Is a Pass-Through Entity?
Pass-through entities are structured entities that offer business owners a more favorable tax rate while still protecting the owner or members from personal liability. For federal income tax purposes, types of pass-through entities include sole proprietorships, partnerships, LLCs, and S Corporations.
Because pass-through entities do not pay income taxes on a corporate level, they can provide an alternative to the double taxation that occurs in a Corporation business structure. With a pass-through entity, the owners share the income, and their income levels determine the amount of tax they owe.
Pass-through entities, or flow-through entities, make up over 60 percent of all business entities in the United States.
Reasons to Consider Using a Pass-Through Entity
Business owners use pass-through entities to avoid double taxation on business assets, income streams, or transactions. Typically, for example, corporations pay income tax once when they earn income and then again when they distribute profits as dividends to shareholders.
Small businesses and start-ups often find double taxation cumbersome and unfair. By structuring their business as a pass-through entity, the owners are only taxed once on business income.
Other reasons to consider a pass-through entity include the following:
- Favorable tax rates. The revenue of pass-through entities encounters only one layer of tax and lower rates than C corporations, since their revenue is being taxed as individual income.
- Increased popularity. The number of businesses constructed as pass-through entities has increased in the United States over the last thirty years. In fact, more than half of the private sector workforce is employed by pass-through entities. Meanwhile, C corporations are on the decline.
- More net income. Pass-through businesses earn more net business income than C corporations.
- No size restriction. Not all pass-through entities are small businesses. They range from single person entities to thousand employee companies. There is no limit to the size of the enterprise.
Reasons Not to Consider Using a Pass-Through Entity
Pass-through entities are not without their drawbacks. For instance, the majority of pass-through business income is taxed at the highest individual tax rates. In some states, marginal tax rates can end up being higher than 50 percent. Also, individual tax code reform will address the increase in pass-through entities and their effect on tax revenue. The changes may make pass-through entities a less attractive option.
Types of Pass-Through Entities
There are several types of pass-through entities, and each has its own challenges. There may be restrictions on the number of owners or the type of members, and some fringe benefits may not be available. It is important to weigh your business's needs carefully to pick the right entity.
- Master Limited Partnerships (MLPs) are made up of general partners and limited partners. General partners handle the day-to-day operations, including hiring and firing decisions, setting policies and procedures, and managing production, marketing, and sales. Because general partners make all of the decisions and assume more of the risk, they receive a bigger share of the profit.
Limited partners, on the other hand, have no daily management responsibility. They are individually liable for the business's debts. Their share of both the equity and the liability is limited to the amount of money they invest in the business.
- Limited Liability Companies (LLCs) share characteristics of a both a corporation and a sole proprietorship. It is the only business entity that can have one member. All members of the LLC share the liability of the entity equal to their equity.
- S corporations are the fastest growing type of pass-through entity. It is most similar to a corporation. The business owner must elect to be considered an S corporation and can only do so if the company is limited to 100 shareholders, has only individuals (not other business entities) as shareholders, has no nonresident aliens as shareholders, and has only one class of stock for all shareholders.
What Could Happen When You Create a Pass-Through Entity?
Pass-through entities face the same tax rules as a C corporation in the areas of inventory accounting, depreciation, and other provisions that determine a businesses profit. To determine taxable income, individuals deduct business losses from their current income.