Pass-Through Entity: Taxes and Business Types Explained
What Is a Pass-Through Entity?
A pass-through entity doesn’t pay business taxes of its own. The income, losses, credits, and deductions of the business flow through to each owner’s personal tax return, and the profits are taxed at each owner’s personal income tax rate. Pass-through entities include sole proprietorships, partnerships, limited liability companies, and S-corporations.
Starting a small business has its fair share of challenges, not least among them being how to figure out the legal aspects of creating a company. Luckily, there are several online legal services to help you make the right decisions for your company, including which business entity structure will serve you best.
Over the last 40 years, the number of pass-through entities in the U.S. has soared. According to the National Bureau of Economic Research, pass-through entities accounted for 54% of U.S. business income in 2011, up from 21% in 1980. Pass-through business entities are popular because they make tax filing easy, and avoid the problem of double taxation that plagues C-corporations.
With so many businesses organizing as pass-through entities, it this the right choice for you? In this guide, we’ll define pass-through entity, describe the different types of pass-through entities, and explain how pass-through taxation works. We’ll even go through some detailed tax examples so you can determine if this business form is right for you. Finally, we’ll explain what steps you need to take to start a pass-through entity.
Types of Pass-Through Entities
There are currently four types of pass-through business entities in the U.S., as follows:
| Type of Pass-Through Entity | Definition | Tax Forms |
|---|---|---|
|
Sole proprietorship
|
Unincorporated business run by one owner or by spouses
|
Schedule C
|
|
A business run by multiple individuals, who share in the assets and liabilities of the business
|
Form 1065 and Schedule K-1
|
|
|
A business that offers limited liability to owners, but has fewer compliance requirements than a corporation
|
Form 1065 and Schedule K-1
|
|
|
A type of corporation that can issue up to 100 shares of stock and a single class of stock
|
Form 1120S and Schedule K-1
|
None of these pass-through entities pays a corporate income tax. Instead, the profits of the business flow through to the owners’ personal tax returns. Owners pay taxes on their share of the business profits in accordance with the individual income tax code.
Among the major types of business entities, only the C-corporation is not a pass-through business. So when deciding on a business structure, you’re essentially deciding between a pass-through entity and a C-corp.
How Are Pass-Through Entities Taxed?
The main difference between pass-through entities and C-corps is the way in which business taxes are paid. C-corps file Form 1120 with the Internal Revenue Service (IRS) and pay a flat corporate income tax of 21% on business profits. Shareholders also pay personal taxes on corporate profits when they receive a dividend or when they sell stock. Dividends can be taxed in the same way as ordinary income tax rates or as capital gains. Since owners of C-corps pay taxes twice, C-corps are said to have double taxation.
Unlike C-corps, pass-through businesses don’t pay any taxes at the entity level. Some pass-through entities file information returns with the IRS, but there’s no tax payment that the company actually submits with these forms. For example, S-corps have to file Form 1120S, and partnerships and LLCs have to file Form 1065. Partnerships and LLCs also have to fill out and provide a Schedule K-1 to each owner, which summarizes each owner’s share of the business’s profits and losses. Sole proprietorships don’t have any informational returns. The owner simply reports business income on a Schedule C and attaches it to their Form 1040.
Keep in mind that in addition to federal taxes, owners of pass-through entities also have to pay their share of state and local taxes. The tax rules for pass-through entities are the same at the state and local levels, with the exception of states that don’t levy income taxes.
Pass-Through Entity Tax Reform
The Tax Cuts and Jobs Act, passed into law at the end of 2017, enacted tax reforms which affect pass-through entities. Owners of pass-through entities can now claim a 20% deduction of their share of business income before paying federal income taxes. Take the basic example of a sole proprietor who earns $100,000 of business income. The business owner can deduct $20,000 from their taxable income, only paying taxes on the remaining $80,000.
As with most business tax deductions, there are a lot of rules around eligibility for the pass-through deduction. It’s only available in full to taxpayers whose total taxable income is below a limit that gets adjusted annually for inflation. For 2019, that limit is $321,400 for married, jointly filing taxpayers and $160,700 for single filers. If your taxable income exceeds that limit, then the deduction phases out based on the amount of wages you pay and the property your company has. At high-income levels, the maximum deduction is still 20%, but the deduction is further limited to the greater of:
- 50% of the wages you’ve paid to W-2 employees; or
- 25% of W-2 wages, plus 2.5% of the acquisition cost of depreciable business property
If you don’t have any employees or business property, and are past the income limit, you can’t claim any deduction at all. This is an incentive for business owners to hire workers and invest in property.
As an example, say Sandy and Greg own a restaurant that they’ve organized as an S-corp. They are married filing jointly and earned $500,000 for the year. Since they earn above the income threshold, they are limited by the wage and property rules. Sandy and Greg paid $100,000 in wages to their employees, and the acquisition cost of their property is $40,000. Under the rules, their deduction will be $50,000, half of the W-2 wages.
Certain types of service providers, like doctors, lawyers, and consultants, can’t claim the deduction at all if their income tops $421,400 for married, joint filers or $210,700 for single filers (these are 2019 limits). Calculating the pass-through entity tax deduction can be complicated, so we recommend asking a tax professional for help.
C-Corporation vs. Pass-Through Entity Tax Example
Many people choose to structure their business as a pass-through entity in order to save on taxes. But a pass-through structure might not always be the best for tax savings. Depending on your income, you might be better off with a C-corp. Here are some simple examples we can compare. We’ll assume that the taxpayer is the sole business owner, has no income streams outside of the business, and is filing as a single filer.
1. In this example, a pass-through entity saves you more money:
Total income: $200,000
20% pass-through deduction: ($40,000)
Taxable income: $160,000
Federal income tax bracket is 24% for 2019: $160,000 x 24% = $38,400
If you were a C-corp, you’d pay 200,000 x 21%, which is $42,000.
2. In this example, a C-corp structure saves you more money:
Total income: $430,000 (the company paid $100,000 of W-2 wages and owns $50,000 worth of property)
20% pass-through deduction: ($50,000)
Taxable income: $380,000
Federal income tax bracket is 35% for 2019: $380,000 x 35% = $133,000
As a C-corp, you’d pay $430,000 x 21%, which is $90,300.
As you can see, the better tax situation really depends on your business’s specific situation. At higher income levels, a C-corp might work out better. That said, these simple examples assume that the business owner doesn’t have personal income streams and that the company didn’t distribute any dividends. We recommend working through the different scenarios with your tax professional to find what’s best for you.
Other Differences Between Pass-Through Entities and C-Corps
The way in which income taxes are paid is the main difference between pass-through entities and C-corporations. That’s not the only difference, however. C-corporations have some other advantages over pass-through businesses.
Retained Earnings
A C-corp must pay corporate income taxes on any profits of the business. After paying taxes, any remaining profits can either be distributed as dividends to shareholders or reinvested in the business. Money reinvested in the business is called retained earnings or accumulated earnings.
In a C-corporation, shareholders do not pay any taxes on retained earnings. However, in a pass-through entity, such as an S-corp or LLC, owners have to pay taxes on all earnings, retained or not. This can make it harder for the business to save toward a particular goal, such as launching a new product or opening a new location.
Fringe Benefits
Another advantage unique to C-corporations is the ability to deduct fringe benefits from taxable income. Fringe benefits include things like health insurance, commuter benefits, and paid time off. C-corporations can deduct the full cost of providing these benefits on their corporate taxes. For a flow-through entity, owners have to pay taxes on the value of any fringe benefits they received.
Charitable Contributions
If your company makes a significant amount of charitable donations, then a C-corp might be a more suitable business structure than a pass-through entity. C-corps can deduct charitable contributions as a business expense, up to 10% of the company’s total income.[1] If you’re an owner of a pass-through entity, you might be able to deduct charitable contributions, but only if you itemize your deductions.
Raising Investor Money
Businesses that plan to raise money through investors or venture capitalists typically opt for a C-corp. This is because C-corps allow for the unlimited issuance of stock, but pass-through entities do not. Out of the different types of pass-through entities, only S-corps allow for the issuance of stock, but S-corps are limited to 100 shareholders and one class of stock. C-corps can have unlimited shareholders and multiple classes of stock, making investors more receptive.
Pass-Through Entity Pros and Cons
Ultimately, when deciding between a pass-through entity and a C-corp, you should think about your business’s current situation and future goals. It’s often easier to get started as a pass-through entity, but if you’re planning to raise investors funds in the future or plan to accumulate earnings in the business, then a C-corp will be the better choice.
Here are the pros and cons of pass-through entities:
Pros
- Launching a business is easier for certain pass-through entities, especially sole proprietorships and general partnerships.
- Pass-through entities can avoid double taxation.
- The tax structure is more equitable, passing a higher tax burden onto owners who are at higher tax brackets.
- The 20% pass-through deduction typically allows small business owners to save more in taxes.
Cons
- It’s more challenging to raise investor money without a C-corp.
- Owners of pass-through businesses have to pay taxes on their share of retained earnings and fringe benefits.
- It’s more difficult to deduct charitable contributions if you have a pass-through entity.
How to Form a Pass-Through Entity
The formation process depends on the type of pass-through entity. Sole proprietors and general partnerships are the easiest pass-through businesses to start because you don’t have to file anything with the state. If you’re the single owner of a business, your company is by default considered a sole proprietorship. If you go into business with multiple people, your company is by default considered a general partnership.
The other two types of pass-through entities—LLC or S-corp—require you to file formation documents with your state’s secretary of state. For S-corps, the document is called articles of incorporation. For LLCs, the document is called articles of organization. Once the state receives and verifies your articles, your LLC or S-corp exists.
LLCs and S-corps also have some additional compliance requirements. For example, in a few states, LLCs have to draft operating agreements outlining their governing structure and the rights and responsibilities of each owner. S-corporations have to establish bylaws, hold shareholder and director meetings, draft meeting minutes, make corporate resolutions, and issue stock certificates.
Should you decide to form any business type that requires a state filing, we recommend using IncFile to speed up the formation process. IncFile lets you easily start your LLC or corporation, and they include one year of free registered agent service with every business formation.
Pass-Through Entities: The Bottom Line
The main difference between pass-through entities and C-corps is taxation. C-corps pay corporate income taxes on profits, and shareholders pay taxes again on any dividends. In contrast, for pass-through entities, business profits and losses flow through to the owners’ personal tax returns. Beyond that, there are some additional differences which should help to cement your choice of pass-through entity or C-corp. Make sure you carefully evaluate the pros and cons of every type of business entity because this is a very important decision for your company.
Article Sources:
- EricNisall.com. “7 Reasons Charitable Donations Won’t Reduce Your Taxes“
Priyanka Prakash, JD
Priyanka Prakash is a senior contributing writer at Fundera.
Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.