Pass through entities

What Are Pass-Through Entities?

Pass-through entities are specific business structures that allow profits and losses to be "passed through" directly to the owners' personal income without being subject to corporate-level taxation. This means the entity itself does not pay federal income tax; instead, the owners report the business income or loss on their individual tax returns and pay taxes at their personal income tax rates. This contrasts with traditional corporations, which are taxed at the corporate level before any profits are distributed to shareholders. The concept of pass-through taxation is a fundamental aspect of how various types of businesses are structured and taxed within the broader field of taxation.

History and Origin

The concept of pass-through taxation has been integral to certain business forms like sole proprietorships and partnerships for many years, as these entities are not considered separate taxable entities from their owners. The formal recognition and popularization of more structured pass-through entities like limited liability companies (LLCs) and S corporations gained significant traction in the latter half of the 20th century, offering entrepreneurs liability protection without the burden of corporate double taxation.

A pivotal development in the landscape of pass-through entities occurred with the enactment of the Tax Cuts and Jobs Act (TCJA) of 2017. This comprehensive tax reform legislation introduced Section 199A of the U.S. Tax Code, which established the Qualified Business Income (QBI) deduction. The QBI deduction allows eligible owners of pass-through businesses to deduct up to 20% of their qualified business income, significantly lowering their effective tax rate on such income.²⁷, ²⁸ The legislation was signed into law by President Donald Trump.²⁶ This provision was designed to provide a tax benefit to pass-through businesses, aiming to create a more level playing field with C corporations, whose corporate tax rate was substantially reduced under the TCJA.²⁴, ²⁵

Key Takeaways

• Pass-through entities avoid "double taxation" by having profits and losses reported directly on the owners' personal tax returns.
• Common examples include sole proprietorships, partnerships, LLCs, and S corporations.
• The Tax Cuts and Jobs Act of 2017 introduced the Qualified Business Income (QBI) deduction, allowing eligible pass-through business owners to deduct up to 20% of their qualified business income.
• Owners of pass-through entities are typically responsible for self-employment tax on their share of the business's profits, in addition to income tax.
• Choosing a pass-through structure depends on factors such as liability protection needs, administrative complexity, and tax implications for the owners.

Formula and Calculation

While there isn't a single "formula" for a pass-through entity itself, the most significant tax calculation related to these entities for many owners is the Qualified Business Income (QBI) deduction, also known as the Section 199A deduction.

The QBI deduction allows eligible taxpayers to deduct up to 20% of their qualified business income (QBI). However, this deduction is subject to certain limitations based on the taxpayer's taxable income, W-2 wages paid by the business, and the unadjusted basis immediately after acquisition (UBIA) of qualified property.

For eligible taxpayers, the QBI deduction is generally the lesser of:

1. 20% of the taxpayer's qualified business income (QBI).
2. 20% of the taxpayer's taxable income (before the QBI deduction), reduced by any net capital gains.²¹, ²², ²³

For taxpayers with taxable income exceeding certain thresholds (which are indexed for inflation annually), additional limitations may apply, especially for specified service trades or businesses (SSTBs). The calculation can become complex, involving a comparison of the 20% QBI amount with wage and property limits, or a complete phase-out for SSTBs above higher income thresholds.¹⁸, ¹⁹, ²⁰

Interpreting Pass-Through Entities

Interpreting pass-through entities centers on understanding their tax treatment and legal structure. The primary characteristic to interpret is the single layer of taxation. For owners, this means that the business's profits are taxed only once at their individual rates, potentially leading to a lower overall tax burden compared to businesses subject to corporate income tax.¹⁷

Furthermore, the legal implications of each pass-through structure must be interpreted. For example, a sole proprietorship offers no personal liability protection, meaning the owner's personal assets are at risk for business debts and lawsuits. In contrast, an LLC or S corporation provides liability protection, separating the owner's personal assets from the business's liabilities.¹⁴, ¹⁵, ¹⁶ The choice of entity directly impacts the balance between tax simplicity, administrative burden, and asset protection.

Hypothetical Example

Consider Sarah, a graphic designer who operates her business as a sole proprietorship. In 2024, her business generates $75,000 in net qualified business income. Sarah is a single filer, and her total taxable income before any QBI deduction is $80,000.

To calculate her potential QBI deduction:

1. 20% of QBI: 20% of $75,000 = $15,000
2. 20% of taxable income (before QBI deduction): 20% of $80,000 = $16,000

Sarah's QBI deduction would be the lesser of these two amounts, which is $15,000. This $15,000 is a tax deduction from her taxable income.

This example illustrates how the pass-through nature directly benefits Sarah, as the $75,000 in business income is reported on her personal tax return (specifically, on Schedule C of Form 1040), and she can then claim the QBI deduction to reduce her overall taxable income.

Practical Applications

Pass-through entities are widely used across various sectors of the economy, particularly by small and medium-sized businesses, service professionals, and startups. Their practical applications include:

• Small Business Formation: Many entrepreneurs initially choose a sole proprietorship, partnership, or LLC due to their relative ease of formation and the direct tax treatment. This simplifies tax compliance compared to traditional corporations.¹², ¹³
• Professional Services: Firms in fields like law, accounting, and consulting often operate as partnerships or LLCs, allowing individual professionals to be taxed on their share of the firm's profits while limiting personal liability.
• Real Estate Investment: Real estate investment partnerships and some trusts are structured as pass-through entities, enabling investors to receive income and potentially pass-through losses directly, which can offset other taxable income.
• Startup Funding: While C corporations are typically preferred for venture capital funding due to their structure for issuing various classes of shareholders and attracting external investors, many startups begin as LLCs or S corporations and convert to C corporations later if they seek significant outside investment.
• Tax Planning: The availability of the QBI deduction provides a significant tax planning opportunity for eligible pass-through business owners, allowing them to reduce their federal income tax liability.¹¹ Taxpayers whose income exceeds certain thresholds, or who operate specified service businesses, must carefully plan to maximize this deduction.¹⁰

Limitations and Criticisms

Despite their popularity and tax advantages, pass-through entities come with certain limitations and have faced criticism, primarily regarding equity and complexity.

One primary limitation for owners of pass-through entities, particularly sole proprietors and partners, is the potential for unlimited personal liability for business debts and obligations. Unlike a C corporation or an LLC, a sole proprietorship or general partnership does not create a legal distinction between the owner and the business, exposing personal assets to business risks.⁸, ⁹

Another criticism often leveled at the Qualified Business Income (QBI) deduction, a significant benefit for many pass-through entities, is that it disproportionately favors high-income individuals and certain types of businesses, potentially exacerbating income inequality. Some analyses suggest that a large share of the QBI deduction benefits are claimed by businesses with no employees, raising questions about whether the deduction effectively stimulates job growth or investment as intended.⁷ Furthermore, the rules surrounding the QBI deduction are highly complex, with intricate phase-ins, income thresholds, and limitations for specified service trades or businesses (SSTBs), making it challenging for taxpayers to calculate accurately without professional assistance.⁵, ⁶

Additionally, while pass-through entities avoid double taxation, their income is taxed at individual ordinary income tax rates, which can be higher than the corporate tax rate for C corporations at certain income levels. Owners of pass-through entities are also generally subject to self-employment tax (Social Security and Medicare taxes) on their share of the business's earnings, which adds another layer of taxation that W-2 employees or C corporation shareholders typically do not face in the same way.

Pass-Through Entities vs. C Corporations

The key distinction between pass-through entities and C corporations lies in their tax treatment.

The choice between a pass-through entity and a C corporation depends heavily on the business's goals, profit levels, investor needs, and the owners' individual tax situations.

FAQs

What types of businesses are typically considered pass-through entities?

The most common types of pass-through entities include sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations. These structures generally avoid the direct corporate income tax.⁴

What is the main tax advantage of a pass-through entity?

The primary tax advantage is "single taxation." Unlike C corporations, the profits of a pass-through entity are taxed only once at the individual owner's tax rate, rather than being taxed at both the corporate and individual levels.³ Additionally, eligible owners may benefit from the Qualified Business Income (QBI) deduction.

Do owners of pass-through entities pay self-employment tax?

Yes, in most cases, owners of sole proprietorships and partners in partnerships are subject to self-employment tax (Social Security and Medicare taxes) on their share of the business's net earnings. S corporation shareholders pay self-employment tax on their reasonable salary but generally not on their distributed profits.

Can a pass-through entity offer liability protection?

Yes, limited liability companies (LLCs) and S corporations provide limited personal liability protection to their owners, meaning the owners' personal assets are generally protected from the business's debts and legal obligations. Sole proprietorships and general partnerships typically do not offer this protection.²

What is the Qualified Business Income (QBI) deduction?

The Qualified Business Income (QBI) deduction, also known as the Section 199A deduction, allows eligible owners of sole proprietorships, partnerships, LLCs, and S corporations to deduct up to 20% of their qualified business income from their taxable income. This deduction was introduced by the Tax Cuts and Jobs Act of 2017.¹