Common examples of pass-through entities include sole proprietorships, partnerships, limited liability companies, and S-corporations. We’ll explore each of these in detail below.
Alternate name: Flow-through entities
How a Pass-Through Entity Works
Earned money is usually taxable. Individuals pay personal income tax on their salaries and businesses pay corporate tax based on the revenue the organization generates during a financial year. Unfortunately, this means business owners can face double taxation that forces them to pay a personal income tax on the money they make through their business and also pay a corporate tax under the business’s name. To avoid this, a large majority of businesses register as pass-through or flow-through entities. Under these, the income generated is considered solely the income of the investors, stockholders, or owners. Therefore, the earnings and the taxes directly pass or flow through to the individuals. Because the earnings are now taxed as personal income, the usual personal income tax rates apply and businesses can avoid paying hefty corporate tax rates. However, not every pass-through entity works the same way. Each type has different tax rules, as we’ll see below.
Types of Pass-Through Entities
The best part about running a pass-through entity is that business owners have a wide variety of options to choose from. Here are the four types of pass-through entities to help you explore the reasons why you should or shouldn’t choose each one.
Sole Proprietorships
Sole proprietorships are among the most common types of pass-through entities, as they are the default option for most independent contractors or freelancers. Sole proprietorships are single-owner businesses and tend to be easier to set up. However, such businesses also have fewer legal and financial protections. Pass-through entities registered as sole proprietorships calculate taxes on Schedule C of Form 1040. This type of pass-through entity is suitable if you’re a new business owner just getting started by yourself. You can switch to another model once you start hiring employees or partner with other individuals and organizations.
Partnerships
Small businesses bigger than sole proprietorships are typically registered as partnerships. These are companies owned by two or more people and they need formal registration with legal ownership percentages. Partnership businesses file an entity-level tax through Form 1065. Choose a partnership structure if your business has multiple owners but isn’t large enough to be a corporation.
Limited Liability Companies (LLCs)
Limited liability companies (LLCs) are divided into two types: single-member LLCs and multi-member LLCs. Single-member LLCs are taxed similar to sole proprietorships, while multi-member LLCs are taxed as partnerships. Members in single-member LLCs pay a personal income tax; partners in multi-member LLCs fill out Schedule K-1, which shows their share of the business profits on Form 1065.
S Corporations
Businesses that choose this status file corporate tax through Form 1120S; however, the profits are directly passed on to the owners and shareholders to be reported on Schedule E of Form 1040. Owners aren’t required to pay SECA tax on their profits but need to pay “reasonable compensation,” which is taxed under the Federal Insurance Contributions Act (FICA). Each type of pass-through entity has something different to offer, depending on your current business model and future goals. If you’re unsure about which business structure is right for you, speak with a legal or accounting expert.
