If you’re a small business, chances are you’re already a pass-through entity. In fact, 95% of all businesses in the U.S. are pass-throughs. And the type of pass-through you are can affect the amount of taxes you pay.
Even though pass-through entities are everywhere, the concept can still feel a bit murky. Maybe you’re wondering if your business qualifies, or what exactly is “passing through” in the first place. Fortunately, it’s simpler than it sounds—and once you nail down the basics, you can optimize your business structure for the best possible tax outcome.
What is a pass-through entity?
A pass-through entity is a business in which income is passed through to the owner, partner or shareholder and taxed at the individual level rather than on the business’s tax return.
Sole proprietorships, partnerships, S corporations, LLCs (limited liability companies), and SMLLCs (single-member LLCs) can all be structured as pass-through entities and reap the tax advantages they offer.
In contrast, C corporations, like Apple and General Motors right on down to incorporated small businesses, are taxed at the business level and thus are not pass-throughs (even though shareholder dividends are taxed, too).
What are the different types of pass-through entities?
Let’s take a look at several kinds of pass-through entities and the pros and cons of each:
Sole Proprietorships
Sole Proprietorships are considered pass-throughs for tax purposes, since income from the business “passes through” to the single owner, who files as an individual.
Profits are not double taxed like corporations that get hit on the business level and again when shareholders receive dividends. Score one for the sole proprietor. It’s also an easier and less costly business to set up.
On the downside, since sole proprietors file a Schedule C, they must pay a self-employment tax; and if they hire others, payroll taxes. Sole proprietors are also vulnerable to liability claims on their personal assets.
S Corporations
S Corporations are tax entities that pass through distributions and losses to shareholders who report them on their personal returns at individual tax rates. Thus, they avoid paying the self-employment tax, unless they also receive “reasonable compensation” in the form of a salary; then they pay the SE tax on that portion of their income.
In an S corporation, a Schedule K-1 must be filed to report income, deductions, credits and losses for each shareholder. To become an S corporation, you file Form 1120-S in addition to your tax return.
Limited Liability Companies (LLCs)
LLCs are considered pass-through entities because they are not subject to corporate income taxes. As a legal entity, members’ personal assets are also protected from liability claims.
LLCs are eligible to become S corporations where shareholders are taxed as individuals and avoid the self-employment tax. But if they elect to file as a Schedule C, they would be subject to that tax.
Single Member LLCs
SMLLCs, or single member limited liability companies, are among the most common types of small businesses in the U.S., benefiting from both pass-through status and personal asset protection. SMLLCs can minimize taxes owed, reduce paperwork and shield the single member from business debt.
Like multi-member LLCs, SMLLCs may incur additional tax filings and compliance costs.
Partnerships
Partnerships are pass-through entities that don’t pay federal income tax. Rather, their profits and losses are passed directly to the partners, who report them on their individual returns and avoid paying the double tax.
The entity doesn’t have the same tax benefits as an S corporation, but more flexibility in their ownership structure. The partnership itself must file Form 1065 as an entity, as well as a Schedule K-1 for each partner.
When do I need to file my pass-through tax return?
If you file taxes as a partnership or S corporation, you must submit your returns by the 15th day of the third month after the end of your tax year. If your fiscal year is the calendar year, that date is March 15th.
LLC and SMLLC pass-throughs filing a Schedule C must submit their Form 1040 returns by April 15th, or October 15th with an extension. If filing your LLC as an S corporation see above paragraph for deadlines.
Regardless of your business structure, it’s always wise to start filing early to handle any tax data collection or other hiccups that may arise, given IRS staff and budget cuts that may delay getting help from them.
Keep accurate records to optimize tax savings
It’s important to maintain detailed records on both the business entity level and as individual owners, partners, members, or shareholders. Not just to avoid errors, inconsistencies and IRS scrutiny, but to ensure you get every deduction and tax advantage your pass-through structure allows.
The bottom line
Choosing the right business structure for your needs is a critical decision that will affect your taxes, liability and many other aspects of your business for years to come.
That’s why it’s well worth seeking the guidance of a professional who has both legal expertise in setting up your business and fiscal savvy in minimizing your taxes.
At DiMercurio Advisors, we specialize in both of these areas for small business owners. Whether it’s registering your business, accounting services, tax preparation, budgeting and more, we can help. Get in touch with an advisor today and ask how we can tailor our expertise to your business.
