What is a Pass Through Entity?
Most small business owners form what are called “pass-through” entities. Sole proprietorships, partnerships, LLCs and S Corporations are pass through entities for federal income tax purposes. A pass through entity is a special business structure that reduces the effects of double taxation. Pass through entities do not pay income taxes at the corporate level, but allocate taxes among the business owners. Thus, taxes are levied on an individual basis.
Types of Pass Through Entities
A sole proprietorship is an unincorporated business where one individual owns and controls the proprietorship. Generally, there is no distinction between the business and the owner. A sole proprietor must report all business income or losses on its personal income tax return; the business itself is not taxed separately.
Where two or more people share ownership of a business, they form a partnership. Each partner contributes to the business in all aspects. Partnerships are typically easy to form; however, partners must seriously consider the development of the partnership agreement. An experienced attorney can counsel partners in forming enforceable partnership agreement.
In sum, S corporations are ordinary business corporations; however, S corporations make a valid election to not pay income taxes. S corporations elect to pass corporate income, losses, deductions, and credit through their shareholders.
Generally, pass through businesses face the same tax rules as C Corporations for the measurement of business profits. One advantage to organizing a pass through business is that income is taxed at one layer. This is unlike C corporation profits which are subject to corporate income tax and then again as dividends to shareholders. You can read more about this here.
Another benefit of pass through companies is that individuals can deduct losses against current income from other sources for “passive losses”. A passive loss is a financial loss within an investment in any trade or business enterprise in which the investor is not a material participant.
If you would like to know more about pass through entities or are considering starting a business, contact us. We look forward to assisting you with your endeavors.