One of the most prominent business structures in the US is the pass-through entity. In fact, according to research published by the Tax Foundation, in 2011, pass-through businesses employed “more than 50% of the private sector workforce” in the country. These businesses not only file more tax returns but also generate higher incomes that the C corporations.
This article discusses in detail what exactly are pass-through entities and how they are taxed.
It is a special structure of doing business which specifically tackles the implications of double taxation. To achieve this, pass-through entities are not taxed at the corporate level. Rather, the income from the business is allocated to the owners, who then pay the individual income taxes.
Some examples of pass-through entities are sole proprietorships, Limited Liability Companies (LLC), Limited Liability Partnerships (LLP), S corporations, etc.
As mentioned, these businesses are not directly taxed by sending a percentage of the profit to the IRS (Internal Revenue Service). Instead, the profit is “passed through” to the owners of the company. These individuals then have to pay the required income taxes to the IRS. Thus, pass-through entities pay taxes at the individual tax rates and not the corporate rates.
The following are some important points with regards to pass-through entities:
Unlike the C Corporations that pay their taxes twice (corporate and shareholder levels), pass-throughs undergo only one taxation layer. This is the income tax that is paid by the owner(s).
Apart from the individual income taxes on the owners’ returns (which can be a max of 37% at the federal level), pass-throughs also pay the state and local taxes and self-employment taxes.
While most small businesses are structured as pass-through entities, not all pass-throughs are small. In fact, some pass-through entities are quite large, employing thousands of people and generating billions in revenue.
In 2017, the Tax Cuts and Jobs Act provided a provision for deductions for households that have pass-through incomes. This allows the taxpayers to get federal income tax relief on up to 20% of their pass-through income.
Most of the pass-through business income is earned by the high-income group. For example, in the tax year of 2016, about 45% of the pass-through income was earned by people who had an annual adjusted gross income of more than half a million USD. In comparison, in the same year, taxpayers with an adjusted gross income of $100,000 constituted about 22% of the pass-through income earners.
Knowing the details about pass-through entities and their tax mechanisms can help you immensely in setting up your business efficiently. At Foster Financial CPA, we assist our clients who are looking for financial and tax advice. Contact us today to know more about our services and learn how we can help you in this regard.