Selecting a business type is a lot like buying a car. There are pros and cons to consider with every vehicle and some will be more suited to your individual needs than others. The same is true when setting up a business. That said, tax treatment is one of the major issues that could lead you to choose one type over another.
With that in mind, the term “pass-through” entity comes up a lot in the literature on business formation. Simply put, a pass-through entity is a company that does not pay corporate tax. Instead, the income “passes through” to the owner, meaning the tax obligation is paid only once on his or her personal return. As you can imagine, this feature can be a major advantage.
Types of Pass-Through Entities
Keep in mind that most business types other than C corporations are considered pass-through entities, including:
- Sole proprietorships – meaning doing business on your own without incorporation
- Partnerships – meaning doing business with another person
- S corporations – meaning small corporations that elect to be taxed differently than C corporations
Note that limited partnerships are also pass-through entities. These businesses provide some liability protection and require certain filings to be made with the state.
Now, if you choose to organize as a limited liability company (LLC), you have two options. First, you can elect to be taxed as a C corporation. In this case, your business would not be a pass-through entity.
However, you can also choose to be taxed as a sole proprietorship, partnership or S corporation. As mentioned, these are all pass-through entities. That said, how you decide to set up your LLC typically comes down to how many owners you have as well as other tax considerations.
Taxes for Pass-Through Entities
Now, when it comes to taxes, the process for reporting income depends largely on the type of business you formed. First, you will need to calculate your company’s net income. This is done by adding up your annual revenue and subtracting deductible expenses.
For partnerships, net income is then reported on a partnership return that is filed with the state and the federal government. This is true even though the partnership does not pay tax.
Keep in mind that sole proprietorships do not file a business return. Instead, any income earned is simply reported on a Schedule C filed with the individual’s 1040.
Note that the tax rate paid will be based on the owner’s personal tax rate. This takes into consideration all of the individual’s income and deductions.
The 20% Pass-through Tax Deduction
It’s important to be aware that the Tax Cuts and Jobs Act (passed in 2018) introduced the 20% pass-through deduction. This means that business owners can deduct up to 20% of “qualified business income” from their personal taxes.
Now, in order to be considered qualified business income the earnings must be generated from a pass-through entity (as defined above). Note that income in this context means profit from the business (revenue – expenses), but does NOT include money received as wages, interest, or dividend income.
Note there are some limitations that come into play if your annual income (from all sources) is more than $50K if you are an individual and $100K if you are filing as a married couple. For that reason, it is important to speak with an attorney or an accountant if your income exceeds this threshold.
A Note on Self-Employment Tax
As you can see, there are certain tax advantages to having a pass-through entity. However, bear in mind that new business owners may not be aware of the self-employment tax. This is a tax that is paid by the individual, not the business.
Self-employment tax includes social security, medicare, and federal income tax. This is important to remember because when you are self-employed no one is deducting these amounts from your paycheck.