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Pass Through Entity | What is a Pass Through Entity?

Pass Through Entity | What is a Pass Through Entity? published on

PASS THROUGH ENTITY

A pass through entity—also known as a flow-through entity—is a type of business structure that avoids double taxation by having its income and losses taxed only at the member level. The government regards income from a pass through entity as that of the owners, shareholders, partners or members—therefore the business itself isn’t taxed. The amount of tax a member has to pay depends primarily on their income levels.

Types of Pass through Entities Include:

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Pass Through Entity Business

The types of business entities that are not pass through entities are C corporations, along with LLC’s and S corporations that choose taxation as a corporate entity—which they might arrange if they have a large number of investors or if there’s a lot of risk for them in the business venture.

Pass Through Entity Income

Pass through entity income includes:
  1. Pass Through Entity income from a Partnership
  2. Pass Through income from an S Corporation
  3. Pass Through income from Rental Properties
  4. Pass Through income from a Sole Proprietorship
  5. Pass Through income from a Limited Liability Company
Pass through Tax
Unlike the pass through tax structure of an S Corporation, the double taxation that a regular corporation is subject to could result in a combined tax rate of 70% or higher! A Sub-Chapter S Corporation has a pass through tax arrangement that is exempt from federal and state corporate Income Tax so that the earnings of the Corporation flow directly to the owners. This pass through tax formation offers an attractive form of doing business because it combines the business and legal characteristics of a corporation with many of the pass through tax characteristics of a partnership.
S Corporation Taxes
If you are a Citizen or Permanent Resident of the United States, it is the most tax-favorable type of Corporation you can have! It can enjoy distinct tax advantages, but it does come with conditions:
  1. It can’t be a domestic, international sales organization, possessions corporation, insurance company or bank.
  2. It can’t have more than 100 shareholders.
  3. Must not have shareholders other than individuals, estates, certain trusts, or certain tax-exempt organizations.
  4. Must not have non-resident alien shareholders.
  5. Must not have more than one class of stock.
LLC Pass Through Taxes

A Limited Liability Company (LLC) taxed as a partnership—or sole proprietorship—may have advantages over an S Corporation. The amount of a Subchapter S Corporation shareholder’s deductible losses is limited to the sum of the shareholder’s basis in his stock and any loans from the shareholder to the corporation. In contrast, a partner can deduct losses in an amount up to the sum of the basis in the partnership interest, the allocable share of partnership income, and his allocable share of qualifying partnership debt.

How the taxes work is simple; For example, each of 10 individuals contributes $100,000 to acquire an office building, then the entity borrows from a bank an extra $5,000,000 as the balance of the building’s $6,000,000 purchase price. If taxed as an S Corporation, each shareholder has a loss-deductions confined to $100,000. However, if the entity is an LLC taxed as a partnership, each member can deduct losses up to $600,000 ($100,000 basis plus $500,000 share of the entity’s debt). These losses may then be used by the individuals to offset other income they may have from other sources.

Partnership Taxes

A general partnership has flow-through tax treatment under Subchapter K of the Internal Revenue Code and therefore a general partnership is not subject to direct taxation. Instead, the partnership must file a return and the partners assume liability for their share of the general partnership’s gain or loss on a form and their individual returns. Avoiding the entity level tax ensures that income flowing into a general partnership is taxed only once.

A general partnership does not have limited liability, meaning that creditors can reach business and personal assets from the partners. For this reason, we advise that clients form a limited liability partnership (if you are involved in the professions of public accountancy, the practice of law, architecture or related to such practice), a limited liability company or a corporation.

Sole Proprietorship Taxes

A sole proprietorship has the same flow-through tax benefit of being a pass through entity—like an S corporation or LLC—but a sole proprietorship does not possess the liability protection of the latter two. Having limited liability protects your car, boat, house, and other personal assets from being used to pay debts; it separates you and your business as different legal entities. A sole proprietorship means that you have unlimited liability and full personal responsibility for all debts and legal actions facing your business.

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