What Is A Pass-Through Entity?
As a business owner, you work hard for your money. It only goes to reason that you would work just as hard to keep it.
Many small businesses come to us looking for ways to decrease taxes (legally!) and keep more of the spoils of their labor.
While there are a variety of strategies that we can use to help business owners and investors decrease their tax liability, one of the foundational elements is the actual way that their business is taxed based upon the business structure.
Different entity structures are taxed in different ways. As your tax advisors, it’s our job to make sure you are utilizing the most beneficial structure for your business that gives you the best (and lowest) tax outcome.
This is why a pass-through entity is one of the most common entity structures for small businesses. They tend to provide tax benefits that equate to less taxes. But despite their commonality, many business owners still have numerous questions about them. Here we’ll explore a few.
So, what is a pass-through entity?
A pass-through entity is formed for the purpose of avoiding double-taxation. It is a special business structure by which you file your business with the IRS that later determines the way your business income is taxed.
What are the benefits of a pass-through entity?
Pass-through entities don’t pay income taxes at the corporate level. The net income from the corporation or business is allocated among the entity’s owners, and then taxed based upon the individual owners’ level of taxation.
Are there different types of pass-through entities?
The following business structures are all taxed as pass-through entities:
Sole Proprietorship: It is like it sounds…you are it. You are the only owner and the only one responsible for all profit, losses and responsibilities. All risks associated with the business debts and liabilities are attached directly to you as the individual, not the business.
Partnership: A partnership is any business owned by two or more people. There are both Limited Partnerships (LPs) and Limited Liability Partnerships (LLPs). While these are unique in structure from each other, remember that they are both taxed as pass-through entities.
Limited Partnerships have one general partner that assumes all the risks of the business, including any liabilities, while the other partners have protection from business liabilities. Limited Liability Partnerships protect all partners from the business’s liabilities as well as from each other.
Limited Liability Company (LLC): LLCs also provide limited liability to the members but are not a tax entity themselves, so they must be taxed either as a sole proprietor, partnership or as a corporation. Members of an LLC are considered self-employed and, as such, must pay self-employment taxes.
S Corporation: S Corporations are still considered corporations, but do not suffer from the double taxation that C Corporations have. S Corporations allow business profit to pass directly through to the owners where that income will be taxed based upon the individual’s tax rate.
At what rates do pass-through entities get taxed?
That’s one of the beauties of a pass-through entity. It avoids the corporate tax rate (and double taxation) and is taxed at the individual income tax rate.
IRS – Individual Income Tax Rates 2020:
37% for incomes over $518,400 ($622,050 for married couples filing jointly)
35% for incomes over $207,350 ($414,700 for married couples filing jointly)
32% for incomes over $163,300 ($326,600 for married couples filing jointly)
24% for incomes over $85,525 ($171,050 for married couples filing jointly)
22% for incomes over $40,125 ($80,250 for married couples filing jointly)
12% for incomes over $9,875 ($19,750 for married couples filing jointly)
Are there other taxes for a pass-through entity?
Remember that you may still have to pay state and local taxes, depending on the state in which you live. This would include state income tax, property tax and sales tax.
How do I know if I should have a pass-through entity?
If you are making this decision on your own, we would advise you to do hours of thorough research, ensuring you fully understand all the legalities and conditions associated with each entity.
However, it’s always best to discuss these decisions with a certified tax professional as they will understand much more about your tax situation than you will. In the end, they will save you money, not cost it.
Call Perry & Associates today to start on your road to tax savings and more business opportunities.