Pass through entity`

What Is a Pass-Through Entity?

A pass-through entity, also known as a flow-through entity, is a business structure that avoids corporate income tax by passing its income, losses, deductions, and credits directly to its owners, partners, or shareholders. These individuals then report the business's profits or losses on their personal income tax returns and pay taxes at their individual income tax rates. This arrangement falls under the broader category of taxation within financial planning and business structure, contrasting with traditional C corporations which face taxation at both the corporate and shareholder levels—a concept known as double taxation. Common examples of pass-through entities include sole proprietorships, partnerships, Limited Liability Companies (LLCs), and S corporations.

³¹## History and Origin

The concept of taxing business income at the individual owner level has roots in early U.S. tax history. Before the enactment of the corporate tax in 1909, the aggregate view of corporations often prevailed, where most corporate profits were treated as belonging to shareholders and taxed accordingly. T³⁰he modern proliferation of pass-through entities, however, largely accelerated following the Tax Reform Act of 1986. This pivotal legislation significantly lowered individual income tax rates relative to corporate tax rates, making pass-through structures more attractive for entrepreneurs and business owners.

²⁷, ²⁸, ²⁹The shift towards pass-through entities has been pervasive across industries and states, driven significantly by the organizational choices of new businesses entering the market. T²⁵, ²⁶his trend continued through the 2000s, with a substantial reallocation of factors of production from businesses paying corporate income tax to those whose income passes through to individual income tax returns. B²⁴y 2020, the pass-through share of private for-profit employment in the U.S. more than tripled from 1982 levels, rising from 15% to 49%.

²³## Key Takeaways

• Pass-through entities avoid corporate income tax, with profits and losses taxed only at the individual owner's tax rate.
• Common types include sole proprietorships, partnerships, LLCs, and S corporations.
• The rise in popularity of pass-through entities was significantly influenced by the Tax Reform Act of 1986.
• They offer potential benefits such as avoiding double taxation and allowing owners to utilize net operating losses.
• Despite benefits, pass-through entities have faced scrutiny regarding tax avoidance and their impact on income inequality.

Interpreting the Pass-Through Entity

Interpreting a pass-through entity primarily involves understanding its tax implications for the owner(s) rather than the entity itself. Since the business income, deductions, and credits "pass through" to the owners, the financial performance of the entity directly impacts the owner's personal taxable income and overall tax liability. For investors or potential owners, assessing a pass-through entity means examining its profitability and potential for tax deductions or losses, as these directly affect personal finances.

For example, a highly profitable pass-through entity will increase an owner's individual gross income, leading to a higher personal tax burden. Conversely, if the entity incurs a net operating loss (NOL), this loss can often be used by the owners to reduce their tax liability from other income sources. This direct link between business performance and individual tax returns is a defining characteristic.

Hypothetical Example

Consider Sarah, a freelance graphic designer who operates her business as a sole proprietorship, which is a type of pass-through entity. In a given year, Sarah's business generates $75,000 in revenue. After accounting for business expenses such as software subscriptions, office supplies, and professional development courses, her total expenses amount to $20,000.

Sarah's business profit is calculated as:

Revenue - Expenses = Profit
$75,000 - $20,000 = $55,000

As a sole proprietorship, her business itself does not pay corporate income tax. Instead, the $55,000 in profit "passes through" to her personal income tax return (specifically, on Schedule C of Form 1040). Sarah will then include this $55,000 in her total personal income for the year, alongside any other income she might have. She will pay income tax on this amount at her individual tax rate. Additionally, as a self-employed individual, she will also be responsible for self-employment tax (Social Security and Medicare taxes) on this net earnings from self-employment. This illustrates how the financial success of her pass-through entity directly impacts her personal tax obligations.

Practical Applications

Pass-through entities are widely utilized across various sectors due to their distinct tax advantages and flexibility. In small business operations, they are the most common structure in the United States, including local retail shops, consulting firms, and individual contractors. F²¹, ²²or example, a doctor's practice or a law firm might operate as an LLC or partnership, allowing the partners or members to avoid corporate-level taxes.

In the realm of investing, pass-through structures are frequently used for investment vehicles. Many real estate investments, such as those held through a Limited Liability Partnership (LLP) or a Real Estate Investment Trust (REIT) structured as a pass-through, distribute income directly to investors, who then report it on their personal tax returns. This structure simplifies the tax process for investors and can enhance after-tax returns by eliminating a layer of taxation.

Pass-through entities are also prevalent in sectors like private equity and hedge funds, where partners receive direct allocations of profits and losses. T²⁰he Internal Revenue Service (IRS) has recently intensified its scrutiny of pass-through entities of all types and sizes, including partnerships, S corporations, LLCs, and sole proprietorships, establishing a new unit to oversee their compliance. T¹⁸, ¹⁹his increased focus underscores their significant presence and economic impact within the U.S. business landscape.

Limitations and Criticisms

While offering significant benefits, pass-through entities also come with limitations and have drawn criticism, particularly concerning their tax implications and contribution to wealth inequality. One primary concern is that owners of pass-through entities are taxed on their share of the business's income in the year it is earned, regardless of whether that income is actually distributed to them. This can create a situation where owners have a tax liability without receiving the corresponding cash distribution, a concept sometimes referred to as "phantom income."

Furthermore, research suggests that the tax preferences afforded to pass-through businesses, particularly the qualified business income (QBI) deduction introduced by the Tax Cuts and Jobs Act of 2017, have disproportionately benefited high-income individuals and contributed to income inequality. C¹⁵, ¹⁶, ¹⁷ritics argue that this deduction is heavily skewed towards the wealthy, leading to a substantial drain on the Treasury without a discernible boost in broader economic activity, such as increased investment or job creation.

¹², ¹³, ¹⁴Some studies indicate that such tax policies primarily encourage the reclassification of existing income into pass-through income rather than stimulating new economic ventures. T¹⁰, ¹¹his reclassification can weaken the integrity of the overall income tax system and lead to potential avenues for tax avoidance or even evasion, particularly within complex partnership structures where ownership can be opaque. C⁹onsequently, despite their widespread use, the taxation of pass-through entities remains a subject of ongoing debate among economists and policymakers regarding fairness, efficiency, and revenue generation.

⁷, ⁸## Pass-Through Entity vs. C Corporation

The fundamental difference between a pass-through entity and a C corporation lies in their tax treatment. A pass-through entity, as discussed, is not subject to corporate-level income tax. Instead, its profits and losses "pass through" directly to the owners, who report them on their personal income tax returns. This means the income is taxed only once, at the individual owner's tax rate.

In contrast, a C corporation is a separate legal and taxable entity. Its profits are taxed at the corporate level first. If the corporation then distributes these after-tax profits to shareholders as dividends, those dividends are taxed again at the individual shareholder's level. This phenomenon is known as double taxation. While C corporations offer benefits like limited liability for shareholders and easier access to capital markets for large, publicly traded companies, the avoidance of double taxation is a primary reason many smaller and privately held businesses opt for a pass-through structure like an S corporation or LLC.

FAQs

What are the main types of pass-through entities?

The primary types of pass-through entities are sole proprietorships, partnerships, Limited Liability Companies (LLCs), and S corporations. E⁵, ⁶ach has distinct legal and structural nuances, but they all share the characteristic of passing income and losses directly to their owners for tax purposes.

Why do businesses choose a pass-through structure?

Businesses often choose a pass-through structure to avoid double taxation, which occurs with C corporations. By having profits and losses "pass through" directly to the owners, the income is taxed only once at the individual level. This can lead to a lower overall tax burden and allows owners to potentially deduct business losses against other personal income.

⁴### Can a pass-through entity incur losses? How are they treated?
Yes, a pass-through entity can incur losses. When a pass-through entity has a net operating loss (NOL), these losses typically "pass through" to the owners' personal tax returns. Owners may then be able to use these losses to offset other taxable income, potentially reducing their overall tax liability. T³he ability to use these losses is a key advantage for many business owners.

Is the Qualified Business Income (QBI) deduction related to pass-through entities?

Yes, the Qualified Business Income (QBI) deduction, also known as the Section 199A deduction, was introduced by the Tax Cuts and Jobs Act of 2017 and is specifically related to certain pass-through entities. This deduction allows eligible owners of sole proprietorships, partnerships, and S corporations to deduct up to 20% of their qualified business income, subject to certain limitations.

¹, ²### Do pass-through entities pay any taxes at all?
While pass-through entities generally do not pay federal corporate income tax, they may still be subject to other taxes. These can include state and local taxes, payroll taxes (if they have employees), sales taxes, or franchise taxes depending on the jurisdiction and the specific type of entity. Owners are also responsible for self-employment tax on their share of business income in many cases.