What is a Pass-Through Entity?

by | Apr 20, 2022 | Business Financing, Financial Advice, Insights To Business

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When you own a business, there are several ways that a business can handle income, debts, taxes, and other financial components. Many businesses pay taxes on the income they receive, while others pass the income and tax liability through to its owners. When the business allows the income, debts, and taxes to move through to the people who own the business, it is known as a “pass through entity”.

What Is a Pass Through Entity?

A pass through entity is a form of business that passes all of the financial components, both good and bad, through to the people who own the company. Most forms of business are pass through entities, aside from C Corporations. The owner of the business is required to file their income, losses, deductions, and any business tax credits on their own personal tax return. Limited liability corporations are not pass through entities because any losses of the business remain with the business and do not pass through to the owner.

The Structure of Your Business

With small businesses like sole proprietorships or partnerships, the owners aren’t employees of the business. They don’t receive a wage or salary. Instead, they are able to draw their share of the profits out of the bank in what is referred to as an owner’s draw. They can either write themselves a check on the business account or transfer funds from the business account to their personal account. With an LLC, on the other hand, the owner of the business must be put on payroll so they can collect a paycheck.

The Benefits

There are many benefits to this type of business plan. A pass through entity is easy to form and requires very little paperwork. There are minimal business compliance formalities. This means you report less to the government and maintain your own business practices. They must, however, maintain the proper permits and licenses that will allow them to function within the parameters of the law. A pass through entity does not pay tax as a business so the income they generate is only taxed through the owner.

The Cons

The biggest con of a pass through entity is that the business owner isn’t protected against financial loss. Because they are “self-employed”, they may also be forced to pay self-employment tax on top of their other taxes. Not only will the owner find that they are often pushed up into a higher personal tax bracket, but they will be the ones that must pay for any unexpected financial losses that their business incurs through the day-to-day operations. With this type of business, it can be difficult to attract investors if they would ever need to find working capital. The choice to create a pass through entity is up to you. It will depend on what you feel comfortable with when it comes to managing your business income, loss, and tax liability. Owning a business is a dream that many of us have. It’s important to create a business entity that you will be comfortable managing. You will need to understand all of the ins and outs of your business’s financial interests before you determine what type of structure you want to use.