If you own a business, chances are that you, not the business itself, are responsible for paying taxes on the profit generated by the business. Because your business pays its taxes through your individual tax return, it is known as a pass-through entity. A pass-through entity, also known as a flow-through entity, is not a particular business structure, but a tax status enjoyed by any business that does not pay corporate tax.
The majority of businesses are pass-through entities. Every profit-making business other than a C corporation is a flow-through entity, including sole proprietorships, partnerships, and S Corporations. A C Corporation is the only type of business that pays corporate tax, and therefore is not a pass-through entity.
Limited liability companies (LLCs) are pass-through entities by default. Unless the owners of the LLC file paperwork to change the company's tax status, the IRS and state tax agencies tax LLCs as sole proprietorships (for single-owner and husband-wife owned companies) or partnerships (for multi-owner companies). LLC owners can also elect C Corporation tax status by filing additional paperwork with the IRS. If an LLC elects C Corporation tax status, this is the one instance where they would face corporate tax, and would not be a pass-through entity.
A flow-through entity does not pay federal corporate tax. Instead, the business income passes through the business to their owners, and the owners pay tax for the first time on their personal tax returns. In contrast, C Corporations face double taxation. The business pays corporate tax, then the owners pay tax a second time on same income on their personal tax returns.
When tax time comes around, the pass-through company calculates its net income by subtracting deductible business expenses from the gross income of the business. Then, the company distributes the net income to the owners as provided in the internal documents of the company, such as the bylaws or the operating agreement. The owners of the business pay taxes based on their personal tax rate, instead of the corporate tax rate.
While pass-through entities do not pay corporate tax at the federal level, some states might impose a business tax for any incorporated businesses, such as S Corporations, LLCs, and limited partnerships. Your state may refer to these taxes as a franchise tax, annual fee, or a renewal fee. To keep your business in good standing and to avoid penalties, you must pay the state fees and taxes.
Most pass-through entity income is subject to self-employment tax, which includes social security and Medicare. The individual owner or shareholder is responsible for paying self-employment tax, not the business. Forming an S Corporation might allow you to avoid paying self-employment tax on a portion on the business income, with some restrictions.
Another benefit of forming a pass-through entity is the pass-through income deduction, introduced in 2018 as part of the Tax Cuts and Jobs Act. Business owners of pass-through entities may deduct up to 20% of "qualified business income" (QBI) on their personal tax return. This deduction can result in huge tax savings, and offset self-employment tax.
QBI includes most income from pass-through entities, with a few exclusions, such as wages paid to S Corporation owners, interest income, and dividends. For individuals whose yearly taxable income (after deductions) is more than $157,500, tax regulations might limit or completely bar the deduction, depending on the taxpayer's total taxable income and type of business. If your income is above this threshold, it is best to consult with an accountant or tax attorney.
The steps for forming a pass-through entity will depend on the business structure you choose. You will have a sole proprietorship, which is a pass-through entity, as soon as you start doing business by yourself (and in some states, with your spouse). Similarly, you form a partnership as soon as you begin doing business with another person. Forming an LLC takes additional steps, such as filing formation paperwork with the state, but it will be a pass-through entity by default.
Creating a corporation that is a pass-through entity requires additional steps. At formation, your corporation will be a C Corporation by default. To create an S Corporation, after formation you must file additional paperwork with the IRS. Because of the number of restrictions on S Corps, it is not an option for every business.