As a business owner, you may have heard the term Pass-Through Entity. More than 90% of all businesses in the United States are pass-through entities. So what are they, and more importantly, how do you manage one properly?
What is a Pass-Through Entity?
A pass-through entity (PTE) is a business that “passes through” any income or loss to the owners, members, partners, or shareholders. PTEs include:
- Sole Proprietorships
Single-member LLCs can choose to be a disregarded entity or an S-Corp. Multi-member LLCs can choose to be a partnership or an S-Corp. Regardless of which option an LLC chooses, the income or loss of the company will flow through to the members.
How Pass-Through Entity Taxes Work
The company itself does not pay any taxes on its earnings at the federal level. Instead, the owner will report his or her share of those earnings on their individual tax return. That means owners will pay any tax on that business income at their own personal income tax rate. This only occurs at the federal level. States still require PTEs to file a state tax return, but tax rates and types vary at the state and local levels.
The Tax Cuts and Jobs Act
In 2017, The Tax Cuts and Jobs Act created a new deduction for pass-through entities. The pass-through deduction allows taxpayers with PTE income, an exclusion of up to 20%. That means that if you receive income from your pass-through entity, it can reduce the amount of your reported income by 20%. But this deduction can be complex. The Formations team is well-versed in the deduction and its nuances, and our experts are available to answer any of your questions.
PTE Taxes by Business Structure
PTEs are the preferred business structure because of the ideal tax treatment on business income. A pass-through business passes the income, and corresponding tax obligation, onto the owners. The business itself is not taxed on its profits at the entity level. For 2021, the highest federal individual tax rate is 37%, meaning the most tax paid on the business profits will be 37%.
PTEs also pass the benefit of the Net Operating Loss (NOL) deduction on to the owners. If the business has a loss the owners may take an NOL deduction on their individual tax return, meaning owners can reduce their overall taxable income, and save on their tax bill.
Passing the income through to the owner does not mean that the company doesn’t file a tax return. Reporting income/expenses and paying self-employment taxes vary depending on your business entity:
Sole Prop or LLC
- Reporting: Schedule C, Profit or Loss from Business or Schedule F, Profit or Loss from Farming of the owner’s personal 1040
- Self-Employment Taxes: paid on 100% of the profits
- Reporting: Form 1120-S, U.S. Income Tax Return for an S Corporation
- Self-Employment Taxes: paid on only reasonable compensation, which can lead to significant savings
Partnerships or LLCs taxed as Partnerships
These are a bit different. Owners must report the profits of the company, and pay taxes on that money, even if they do not receive a distribution of those profits. For example, if a Partnership has total profits of $100,000 with two equal partners, the partners will each report $50,000 of income and pay tax at their personal tax rate. This tax is due even if the partner, shareholder, or member never receives those funds. So even if that money is reinvested in the business or is used to cover expenses, it’s still taxed.
- Reporting: Form 1065, U.S. Return of Partnership
- Self-Employment Taxes: partners must report both their distributive share of the income or loss and any guaranteed payments as net earnings from self-employment; limited partners only include guaranteed payments from the partnership as net earnings from self-employment
Paying Taxes as a C-Corp
Because C-Corporations aren’t PTEs, they are taxed twice. C-Corps must file Form 1120, U.S. Corporation Income Tax Return, each year and pay corporate income tax on the profits. For 2021 the corporate tax rate is 21%. The C-Corp distributes dividends from the after-tax profits to its shareholders. The shareholders must report these dividends as income and pay tax at their individual tax rate on that income. If the shareholder is in the highest tax bracket, this could mean dividends are taxed at 37%. Profits of a C-Corp could end up being taxed at a rate of 58% (21% + 37%), which does not include any tax liability at the state or local level.
Forty-four states currently levy a corporate income tax ranging from 2.5% to 11.5%. Another four states impose a gross receipts tax, rather than a corporate tax. Only two states, South Dakota and Wyoming do not impose either a corporate income tax or a gross receipts tax. Forty-two states impose a personal income tax. This means the C Corporation is most likely going to be double taxed at the state level as well.
In addition to avoiding double taxation, a C-Corporation can take a Net Operating Loss (NOL), but it is only at the corporate level, providing zero benefits to the shareholders. The shareholders will still pay federal taxes on any corporate dividends they receive. PTEs may also pass the benefit of the NOL deduction on to the owners. If the business has a loss the owners may take an NOL deduction on their individual tax return. This means the owners have the potential to reduce their overall taxable income, and the subsequent tax liability.
Saving on Taxes as an S-Corp
The majority of business formations are pass-through entities. In fact, you are either a C-Corporation or a PTE. But one form of PTE may be better suited to your current situation than another. Especially when it comes to self-employment.
Year-after-year self-employed individuals are hit with 15.3% of self-employment tax on top of their regular income tax. With a few smart steps, you can keep more of your hard-earned money. Our customers save an average of $7,800 a year on their tax bill by becoming an S-Corp.
If you are currently operating as a Sole Prop, Partner, or LLC and would like to see how converting to an S-Corp may save you money, schedule a call with a Formations expert.