What Is a Pass-Through Entity?

a pass through entity business owner reviewing important documents

New businesses are formed as pass-through entities to benefit from favorable tax treatment, and some forms of pass-through entities also offer enhanced protections in the form of limited liability for their owners. These business forms are incredibly beneficial to owners and properly used, saving them tremendously on taxes.

Types of Pass-Through Entities

Pass-through entities generally fall into two types: LLCs and S-Corps. Entities like partnerships and sole-owner companies also have owners paying taxes on the business’s profits on their tax returns and can be considered pass-through entities.

LLCs take several forms depending on the state they are organized in. An LLC can be arranged with a single owner or as a partnership (LLP). Forms of LLCs can include PLLCs, which are professional limited liability organizations like medical practices or law firms where partners can be added and removed regularly. The tax treatment works the same in every case, and the owners benefit from limited liability.

The other form of pass-through entity is an S-Corp. This company form is initially organized as an LLC and then filed with the IRS to be recognized as an S-Corp for tax purposes. S-Corps aren’t based on percentages of ownership but with equity holders that own shares in the company. The number of shareholders is limited to 100, and the company must take on many of the characteristics of a C Corporation, including company bylaws, a board of directors, and regular board meetings.

How Pass-Through Entities Pay Their Owners

Pass-through entities are based on taxing owners so that they avoid the double taxation that comes with ownership in a C-Corp. Whereas a C-Corp pays taxes at the corporate level, and owners then pay taxes on their dividend payments, pass-through entity owners only pay taxes once.

Tax Implications of Pass-Through Entities

While most pass-through entities will file separate tax returns, they do not pay taxes on their earnings as those earnings “pass-through” to the company’s owners equal to their ownership percentage. If the pass-through entity nets $100,000 for the year, an owner with a 20% ownership stake is responsible for paying taxes on $20,000.

At the same time, if the entity records a loss for the year, the owner may take their percentage of the loss on their tax returns.

Sole Proprietorships

A sole proprietorship is unique in that owners record the company’s earnings on their individual tax returns on Schedule C. The company is essentially an extension of the owner and often uses the same tax identification as the owner. Due to the nature of filing the business’s profit or loss on the owner’s tax return, taxes are only paid once and at the owner’s tax rate.

A woman who is a single business owner looking over paperwork at her office

The profits earned by the company are essentially the owner’s wage, and the owner can withdraw funds at any time. Owners will pay self-employment taxes of 15.3% on everything the company earns.[1]

Single-Member LLCs

Even if the company is organized as an LLC if it has a sole owner, its earnings or losses are recorded on the owner’s tax return on Schedule C. Essentially, the tax treatment is precisely like a sole proprietorship except the company is an LLC.

Partnerships

A partnership is two or more people entering into a business relationship [2] to make a profit. Each owner contributes their labor and skills to achieve this end. The partnership will have its own tax identification number and file its own tax return but not pay taxes.

Partnership earnings will pass through to the owners, who will pay their tax rate on their percentage of the earnings. They also pay self-employment taxes on the entire percentage of their share of the profits.

Multi-Member LLCs

A multi-member LLC is essentially a partnership that is filed with the state as an LLC to take advantage of limited liability. As such, its tax treatment is exactly the same as a partnership with the LLC filing tax returns but the owners are liable for taxes and self-employment taxes on the full percentage of profits equal to their ownership percentage.

S Corporations

S Corps are similar to the other entities in that their profits pass through to their owners equal to their percentage of share ownership. Still, they are unique in one regard, which saves owner’s tremendous amounts of money.

Owners that hold more than 2% of the S Corp shares, work within the business, and pay themselves a “reasonable wage” needn’t pay self-employment taxes on their share of company profits. The employment taxes are only paid on the owner’s wage from the company. The company portion of the payroll taxes are deducted from earnings, and the owner only pays for half of those taxes personally.

Whereas owners of the other pass-through entities pay employment taxes on their total share of profits, active S Corp owners avoid those taxes so long as they pay themselves a reasonable wage. They save 15.3% in taxes on their distributions.

Pros and Cons of Pass-Through Entities

Pass-through entities come with both pros and cons, and a business form should always be thoughtfully considered before one is chosen.

Potential Advantages

a single business owner researching what is a pass through entity

The most significant benefit of a pass-through entity is saving on the double taxation inherent with C Corporations. A pass-through entity doesn’t pay the corporate tax rate of 21% on its earnings, and profits are only taxed at the owner’s level.

Pass-through entities formed as sole owners, partnerships, or LLCs are easy to create and manage, with no demanding requirements like a board of directors, annual board meetings with minutes, and bylaws.

S-Corps have many of the same management requirements as C-Corps but eliminate the need to pay self-employment taxes on all of the owner’s percentage of earnings., potentially saving owners significant amounts of money so long as they pay themselves a reasonable wage. 

Pass-through entities also have considerable value to owners as losses pass through, potentially saving them significant amounts in subsequent tax years.

Due to these advantages, most businesses in the U.S. are formed as pass-through entities.

Potential Disadvantages

The most significant disadvantage of all pass-through entities except for S-Corps is that the owners pay taxes and self-employment taxes on all company earnings. This tax treatment could mean they are pushed into a higher tax bracket and pay 15.3% in self-employment taxes. The result could be a significant tax bill, whereas a C-Corp only pays a 21% tax rate, and equity owners only pay personal taxes on their dividends. Furthermore, self-employment taxes are not paid on dividend earnings.

Only an S-Corp prevents owners from paying self-employment taxes on all of the pass-through company’s earnings, but owners still pay personal taxes on the entirety of their percentage of profits.

The C-Corp owner isn’t at risk of a very high tax bill if the company has a banner year but only pays limited dividends.

If you are forming or have ownership in an S-Corp, one of the most essential questions is, “What is a reasonable wage?” Getting that calculation right saves owner’s tremendously on self-employment taxes. RCReports helps S-Corp owners and accountants know what a reasonable wage based on positions, requirements, company sizes, locations, and industries is.

Contact RCReports today to start the process of knowing reasonable wages and saving on self-employment taxes.

Sources

1. 3 Things to Know About Self-Employment Taxes. (2023, October 10). TaxAct. 

https://blog.taxact.com/3-things-know-self-employment-taxes/

2. Tax Information For Partnerships. (2023, February 22). Internal Revenue Service. 

https://www.irs.gov/businesses/partnerships

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