Pass Through Entity - Image of Tax File

What is a Pass Through Entity?

Pass-Through Entities have a unique structure, especially when it comes to how taxes are paid and how the business pays its owners. A Pass-Through Entity is a business type that has no tax liability. Instead of paying taxes as a business, the business income, loss, and any credits that it earns all pass through the business and are claimed by the owners on their individual tax returns. Sole proprietorships, limited liability companies, and most forms of partnerships are pass-through entities. S Corporations also fall into this category.

Paying Their Owners

An owner of a sole proprietorship or partnership isn’t paid in the same way an employee is paid. Instead, they initiate a bank draw out of their portion of the company profits. An owner’s draw usually takes the form of a check or a bank transfer from the company account to their own personal account. One primary difference is the S Corp formation. With this type of setup, owners are put on the payroll where they receive a normal wage, just like every other employee.

Different Types of Taxes

Many businesses pay income tax at a much higher corporate tax rate. With a pass-through entity, the company’s profits are passed through the business to the owners where they are taxed at a lower, individual tax rate. While this may sound appealing, there are factors that can influence how beneficial this is. The different pass-through entity types may differ in how state and federal taxes are handled.

Advantages vs Disadvantages

Pass-through entities are simple to establish and manage. They have very few business compliance formalities which makes them extremely popular among small business owners. There are disadvantages though. In some cases, the self-employment tax that certain types of structures may have to pay can make this a poor choice. Business liabilities may also pose a problem. While this type of business may work for some, it won’t work if you are trying to draw in new investors

Is a Pass-Through Entity Right for You?

If you are trying to decide if a pass-through entity is right for you, you will need to weigh the pros and cons. Know what you are trying to achieve and then have a discussion with your financial advisor. They may be able to provide you with valuable insight as to which type of tax structure or tax strategy would be most beneficial for you as well as your business. Not every business will work well as a Pass-through entity. If you have questions, don’t move forward until you have spoken to a tax professional who can give you the guidance you need when it comes to self-employment taxes and other credits Knowing what your options are when it comes to your company’s tax treatment will help you decide what tax structure you wish to use. Make a list of your priorities and go over them with your tax professional as well. This will give you an idea as to whether or not this type of structure would help you financially or hurt you in the long run.