What Is a Pass-Through Entity?

Pass-through entities are structured entities that offer business owners a more favorable tax rate while still protecting the owner or members from personal liability. For federal income tax purposes, types of pass-through entities include sole proprietorships, partnerships, LLCs, and S Corporations.

Because pass-through entities do not pay income taxes on a corporate level, they can provide an alternative to the double taxation that occurs in a Corporation business structure. With a pass-through entity, the owners share the income, and their income levels determine the amount of tax they owe.

Pass-through entities, or flow-through entities, make up over 60 percent of all business entities in the United States.

Reasons to Consider Using a Pass-Through Entity

Business owners use pass-through entities to avoid double taxation on business assets, income streams, or transactions. Typically, for example, corporations pay income tax once when they earn income and then again when they distribute profits as dividends to shareholders.

Small businesses and start-ups often find double taxation cumbersome and unfair. By structuring their business as a pass-through entity, the owners are only taxed once on business income.

Other reasons to consider a pass-through entity include the following:

  • Favorable tax rates. The revenue of pass-through entities encounters only one layer of tax and lower rates than C corporations, since their revenue is being taxed as individual income.
  • Increased popularity. The number of businesses constructed as pass-through entities has increased in the United States over the last thirty years. In fact, more than half of the private sector workforce is employed by pass-through entities. Meanwhile, C corporations are on the decline.
  • More net income. Pass-through businesses earn more net business income than C corporations.
  • No size restriction. Not all pass-through entities are small businesses. They range from single person entities to thousand employee companies. There is no limit to the size of the enterprise.

Reasons Not to Consider Using a Pass-Through Entity

Pass-through entities are not without their drawbacks. For instance, the majority of pass-through business income is taxed at the highest individual tax rates. In some states, marginal tax rates can end up being higher than 50 percent. Also, individual tax code reform will address the increase in pass-through entities and their effect on tax revenue. The changes may make pass-through entities a less attractive option.

Types of Pass-Through Entities

There are several types of pass-through entities, and each has its own challenges. There may be restrictions on the number of owners or the type of members, and some fringe benefits may not be available. It is important to weigh your business's needs carefully to pick the right entity.

  • Master Limited Partnerships (MLPs) are made up of general partners and limited partners. General partners handle the day-to-day operations, including hiring and firing decisions, setting policies and procedures, and managing production, marketing, and sales. Because general partners make all of the decisions and assume more of the risk, they receive a bigger share of the profit.

Limited partners, on the other hand, have no daily management responsibility. They are individually liable for the business's debts. Their share of both the equity and the liability is limited to the amount of money they invest in the business.

  • Limited Liability Companies (LLCs) share characteristics of a both a corporation and a sole proprietorship. It is the only business entity that can have one member. All members of the LLC share the liability of the entity equal to their equity.
  • S corporations are the fastest growing type of pass-through entity. It is most similar to a corporation. The business owner must elect to be considered an S corporation and can only do so if the company is limited to 100 shareholders, has only individuals (not other business entities) as shareholders, has no nonresident aliens as shareholders, and has only one class of stock for all shareholders.

What Could Happen When You Create a Pass-Through Entity?

Pass-through entities face the same tax rules as a C corporation in the areas of inventory accounting, depreciation, and other provisions that determine a businesses profit. To determine taxable income, individuals deduct business losses from their current income.

Steps to File

The rules for filing a tax return for a pass-through entity are uniform for federal income taxes but vary by state for state income tax returns.

Federal Income Tax

  • Sole proprietorships and one-member LLCs must include all business profit and loss in a schedule C and file it along with the individual income tax.
  • In multimember partnerships or LLCs, individuals pay taxes on their share of the profits or losses. A pass-through entity's operating agreement describes each member's shares. These profits and losses are filed using a Schedule E.
  • An LLC member must pay taxes on his or her whole distribution, whether or not it is distributed every year.
  • Since LLC members are not employees, they may be subject to self-employment tax. Owners who work or manage the business must pay self-employment tax based on their distributed share. Investor members do not have to pay this tax.
  • Much of the business income can be written off by deducting the business expenses. Deductions include office supplies, start-up costs, travel, entertainment, and mileage. This list is in no way exhaustive; a variety of deductions exist to offset income tax.

State Income Tax

  • Most states treat LLC profits the way the IRS does. Rather than the LLC paying state taxes, LLC owners pay state taxes on their personal returns. However, other states assess a tax if the income reaches a certain threshold.
  • Any pass-through entity that falls under Maryland state income tax law must file on Form 510, even if it has no income or is inactive.
  • For record-keeping purposes, a multi-state pass-through entity that operates in Maryland but does not fall under its income tax law can file a return reflecting no income owed to the state. Letters will not be accepted.
  • Qualified Sub-S Subsidiaries are not considered separate entities by Maryland. Instead, they will be included on the parent company's annual Maryland return.
  • Maryland also follows IRS rules for a single member LLC who elects to be disregarded as a separate entity, as well as for certain inactive partnerships that have elected not to be treated as a partnership.

Contact an Attorney or Tax Advisor

If you need help or want more information on creating a pass-through entity, you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or for companies like Google, Menlo Ventures, and Airbnb.