Pass through

What Is Pass Through?

"Pass through" in finance refers to a business structure or investment vehicle where income, losses, deductions, and credits are "passed through" directly to the owners or investors and reported on their personal individual income tax returns. This concept is central to taxation and business structures, as it avoids the issue of double taxation that applies to traditional corporations. Instead of the entity itself paying corporate income tax, the profits are taxed only once at the individual level³⁰, ³¹.

Common examples of pass-through entities include sole proprietorships, partnerships, S corporations, and limited liability companys (LLCs) that elect to be taxed as partnerships or S corporations²⁸, ²⁹. Real Estate Investment Trusts (Real Estate Investment Trusts, or REITs) also operate on a pass-through basis.

History and Origin

The concept of pass-through taxation for certain business entities gained significant traction in the mid-20th century in the United States. Historically, most corporations were subject to taxation at both the corporate level and again when profits were distributed to shareholders as dividends. This "double taxation" was a concern for smaller businesses.

In 1958, the U.S. Congress introduced Subchapter S to the Internal Revenue Code, which allowed certain small businesses to elect S corporation status, thereby enabling their income to "pass through" directly to shareholders without corporate-level income tax²⁷. This legislative change aimed to provide tax relief and encourage small business growth. Similarly, Real Estate Investment Trusts (REITs) were established by Congress in 1960. This legislation, signed by President Dwight D. Eisenhower, aimed to democratize real estate investment, allowing ordinary investors to access income-producing real estate without direct ownership, and mandated their pass-through tax treatment²⁶. This framework allowed REITs to avoid corporate tax if they distributed at least 90% of their taxable income to shareholders annually²⁵.

Key Takeaways

• Single Layer of Taxation: The primary benefit of pass-through entities is that business income is taxed only once, at the owner's individual tax rate, rather than at both the business and individual levels²³, ²⁴.
• Variety of Structures: Many common business structures, including sole proprietorships, partnerships, S corporations, and most LLCs, function as pass-through entities²².
• Investor Access: Investment vehicles like REITs utilize the pass-through mechanism to distribute real estate income directly to investors, offering a way to diversify into real estate without direct property ownership²¹.
• Simplified Reporting: While the entities still file informational tax returns (e.g., Form 1120S for S corporations), the profits and losses are ultimately reported on the owners' personal tax returns²⁰.

Interpreting the Pass Through

Understanding a pass-through structure involves recognizing that the entity itself typically does not pay federal income tax. Instead, the financial outcomes—profits or losses—are directly allocated to the owners or shareholders based on their ownership percentage. These individuals then report their share of the business's performance on their personal tax returns, subject to their applicable individual income tax rates.

F¹⁸, ¹⁹or investors in a Real Estate Investment Trust, the dividends received are generally taxed as ordinary income at the investor's individual income tax rates, unlike qualified dividends from traditional C corporations that may receive preferential tax treatment. Th¹⁷is distinction is crucial for tax planning and evaluating the net returns from a pass-through investment.

Hypothetical Example

Consider "Green Thumb Landscaping," a small business structured as an S corporation. In a given tax year, Green Thumb Landscaping generates $100,000 in net income after all business expenses. As a pass-through entity, the S corporation itself does not pay federal income tax on this $100,000.

Instead, this income "passes through" to its two owners, Alex and Ben, who each own 50% of the company. Each owner's share is $50,000. Alex and Ben will then report their respective $50,000 shares of income on their individual income tax returns (e.g., on Schedule K-1 received from the S corporation). T¹⁶he tax they pay on this income will depend on their personal tax brackets and any other deductions or credits they might have. If Alex is in a 24% tax bracket and Ben is in a 32% tax bracket, they will pay different amounts of tax on their share of the business's profits, even though their income from the company is the same. This illustrates how the tax burden flows directly to the owners, avoiding an additional layer of corporate tax.

Practical Applications

Pass-through taxation is widely applied across various aspects of investing, markets, and business structures.

• Small Businesses: Most small businesses in the United States operate as pass-through entities, typically as sole proprietorships, partnerships, or S corporations. This allows entrepreneurs to avoid the complexities and additional tax burden of a traditional C corporation.
• ¹⁵ Real Estate Investing: Real Estate Investment Trusts (REITs) are a prominent example of pass-through vehicles in the investment world. They enable individuals to invest in large-scale income-producing real estate through publicly traded shares, with the rental income and capital gains passing directly to shareholders. Th¹³, ¹⁴e National Association of Real Estate Investment Trusts (Nareit) provides extensive data on the REIT industry.
• Private Equity and Hedge Funds: Many private equity funds and hedge funds are structured as partnerships, meaning profits and losses pass through to the limited partners and general partners for tax purposes.
• Tax Planning and Policy: The treatment of pass-through income is a significant area of focus in tax reform discussions, as evidenced by provisions like the Section 199A deduction for qualified business income, which allows eligible owners of pass-through entities to deduct up to 20% of their qualified business income.

#¹²# Limitations and Criticisms

While pass-through structures offer significant tax advantages by avoiding double taxation, they also have limitations and criticisms:

• Owner's Personal Tax Rate: The income of pass-through entities is taxed at the owner's individual income tax rates, which can be higher than the corporate tax rate for C corporations at certain income levels. Th¹¹is can sometimes lead to a higher overall tax burden for very profitable pass-through businesses if the owners are in high individual tax brackets.
• Self-Employment Taxes: For some pass-through structures like sole proprietorships and partnerships, all net income is subject to self-employment taxes (Social Security and Medicare taxes). In an S corporation, owners who also work for the business can pay themselves a "reasonable salary" subject to employment taxes, with the remaining profits distributed as dividends not subject to self-employment taxes, but this is closely monitored by the Internal Revenue Service.
• ¹⁰ Complexity for Investors (REITs): While REITs offer pass-through benefits, their dividends are generally taxed as ordinary income, which can be less tax-efficient than qualified dividends from traditional corporations. Ad⁹ditionally, some non-traded REITs can present liquidity issues and may have higher fees compared to publicly traded options.
• ⁸ Income Concentration: Critics note that a significant portion of pass-through income accrues to higher-income taxpayers. For example, a large share of pass-through income is earned by taxpayers with higher adjusted gross incomes, meaning tax benefits associated with these structures disproportionately benefit wealthier individuals.

#⁶, ⁷# Pass Through vs. Double Taxation

The fundamental distinction between a pass-through entity and an entity subject to double taxation lies in how their profits are taxed.

In essence, pass-through entities are designed to eliminate the corporate-level tax, allowing income to "pass through" directly to the owners' personal tax returns, where it is taxed just once. In⁵ contrast, a traditional C corporation faces taxation at the corporate level on its profits, and then shareholders are taxed again when they receive dividends from those after-tax profits, creating a scenario of double taxation.

#³, ⁴# FAQs

What types of businesses are typically pass-through entities?

Common pass-through entities include sole proprietorships, partnerships, S corporations, and most limited liability companys (LLCs). These structures avoid the separate corporate income tax, with profits and losses flowing directly to the owners' individual tax returns.

How do REITs function as pass-through entities?

Real Estate Investment Trusts (REITs) are companies that own or finance income-producing real estate. To qualify for pass-through tax treatment, a REIT must distribute at least 90% of its taxable income to shareholders annually as dividends. This allows the REIT itself to avoid corporate income tax, with shareholders paying taxes on the dividends they receive.

#²## Do pass-through entities pay any taxes at all?
While pass-through entities generally avoid federal income tax at the entity level, they may still be subject to other taxes, such as employment taxes (for employees), state and local income taxes (depending on the state), and excise taxes. The owners of the pass-through entity are responsible for paying individual income taxes on their share of the business's profits.

#¹## Are there any tax disadvantages to a pass-through structure?
One potential disadvantage is that the income from a pass-through entity is taxed at the owner's individual income tax rate, which for high-income earners can be higher than the corporate tax rate for C corporations. Additionally, for some pass-through types, the owner's entire share of income might be subject to self-employment taxes.