Pass Through Partnership: Everything You Need to Know
A pass-through partnership includes limited liability companies, sole proprietorships, partnerships, and S corporations set up for federal income tax purposes.8 min read
A pass-through partnership is a business entity with more than one owner that has elected pass-through tax status with the IRS. Pass-through entities do not pay corporate income tax but instead "pass through" profits and losses to owners, who are taxed directly by the Internal Revenue Service. Subject to IRS Form 1065 reporting of apportioned earnings distribution to owners, income reported on individual tax return filing of Form 1040, and Schedule C or Schedule SE depending on if the business is a sole proprietorship or partnership.
This protects owners from double taxation on profits. In comparison, C-corporations and their owners must report income directly. Taxation of pass-through entities may exceed a marginal tax rate of 50 percent in some states. Although pass-through entities tend to be smaller than C corporations because this structure is so advantageous for small businesses, large corporations can opt for this tax status as well.
Tax Treatment of Business Entities
Tax reforms aimed at improving the competitiveness of U.S. industries typically focus in part on the relevancy of the individual income tax code due to the economic size of pass-through businesses. Sole proprietorships are unincorporated businesses possessed by an individual, reporting income on IRS Schedule C of the 1040 tax form. Partnerships are unincorporated businesses with numerous owners, either other businesses or individual members.
A limited liability company (LLC) is a business structure that protects the owners from liability associated with debts or litigation. Like a customary C corporation, LLCs are established to serve the members of the organization through profit and other benefits. An S Corporation is a small business that can distribute shares to up to 100 shareholders. Owners of S Corporations may only be U.S. citizens, and not foreign partnerships or other corporations.
Sole proprietorships, LLCs, S corporations, and partnerships are all pass-through entities structured to transfer profits directly to members of these firms, who are in turn taxed by the IRS as result of individual income tax return filings.
What Taxes Do Pass-Through Businesses Pay?
Owners and shareholders of C corporations can defer taxation of apportioned income if the entity reports retained earnings or when a shareholder doesn't report a capital gain. Since pass-through businesses quite literally pass the losses and income directly to the owners, the marginal tax rate for individual taxpayers applies. Marginal tax rates are indexed at a rate of up to 39.6 percent of taxable income.
Partnerships and sole proprietorships pay self-employment (SE) tax. These taxes are levied on self-employment income in the interest of funding Medicare and Social Security and are the equivalent to payroll taxes funded by wage earners. Members of partnerships and sole proprietorships must file Schedule SE for “self-employment” on much of their reported net business income. Owners of S corporations have the option of designating income as profit distribution or as wages. S corporation owners are subject to SE payroll taxes on the portion of net income paid out as wages.
The SE payroll tax is charged at 15.3 percent on the first $117,000 in income, 2.9 percent on income from $117,000 to $200,000, and 3.8 on income exceeding $200,000.
Pass-through businesses are obligated to state and local income tax reporting, varying from 0 percent in states that do not have personal income taxes, like Washington state, to 13.3 percent, the top marginal income tax rate imposed in the state of California.
An owner of an S corporation who does not participate in everyday management of the company, but receives income from its activities, will not be charged payroll tax. However, he or she may be responsible for the net investment income tax of 3.8 percent, which was established as part of the Affordable Care Act (ACA).
In some cases, pass-through business owners must pay the Alternative Minimum Tax, which may increase their tax burden.
Tax Differential With Traditional C Corporations
The use of the phrase tax burden differential expresses a ratio between the C corporation and pass-through entity(s). The treatment of taxes of pass-through businesses is different from the tax treatment of C corporations, creating an uneven effect. The double-taxation of corporate income reflects a difference between the complete tax burden on the C corporation and the total income of pass-through entities.
Pass-through business owners face the top marginal tax rate at 47.2 percent at the individual taxpayer level, in comparison with the average total tax rate of 56.5 percent assumed by C corporation reporting of income gained at the shareholder level. This equation assumes that a C corporation has distributed dividends and apportioned earnings distribution to shareholders. Pass-through businesses may report distribution of income to a partnership, yet there is no taxation incurred directly by the business.
C corporations pay higher overall tax on income, but can issue unlimited stock shares that can be registered with the Securities and Exchange Commission (SEC) and traded on the stock market, which provides increased growth potential. More flexible shareholder rules associated to an S corporation make fundraising easier, as well. Deferral of taxation on foreign income, and retained earnings with shareholder tax withholding are key benefits of C corporation status.
Increase in Pass-Through Businesses Filing IRS Tax Returns in the Past 30 Years
Since the enactment of the Tax Reform Act of 1986, the number of pass-through businesses has increased significantly. The act significantly lessened individual income tax rates, making the pass-through structure of business more attractive. Between 1980 and 2011, the number of tax returns filed by pass-through entities raised by 175 percent, up from roughly 10.9 million returns to about 30 million. Between the years 1980 and 2011, the number of S corporations tax return filings rose from about 545,000 returns to more than 4.15 million; an increase of 660 percent, or more than three times the growth rate of the total category of pass-through businesses.
Pass-Through Businesses Are the Most Common Form in the U.S.
Pass-through businesses are the most common entity in the U.S. Sole proprietorships include the majority of all categories of business registrants.
Pass-Through Businesses Are Generally Smaller Than C Corporations, but Pass-Through Businesses Are Not Always Small Businesses
The main reason why C corporations account for the highest percentage of employment in the United States is that they tend to grow significantly larger than pass-through entities on average. Most employment at C corporations is concentrated in large firms. Frequencies of rates of employment at pass-through businesses are shown to be distributed with density across smaller firms.
I have a pass-through partnership (LLC) and a regular day job. Where do I put the income or loss from my partnership on my individual taxes?
LLC partnerships must distribute K-1 filings to all partners of the business and submit to the IRS. The K-1 reports all income and expenses of the LLC, including a record of distributed shares of income and loss. Partners are LLC members, and responsible for IRS Form 1040 and Schedule SE individual income tax return filings.
The main goal of tax reform is to improve competitiveness in the U.S. business environment and grow the overall economy. Lowering taxes on savings and investment with business tax reform is a common legislative policy decision meant to boost investor confidence in economic development. Much business tax reform focuses on C corporation tax code rules, but corporate-only business tax reform ignores pass-through business activity.
How Partnerships Are Taxed
Control of partnership entities demands knowledge of accounting activities associated with distributive shares and special allocations not part of the corporate shareholder structure. These are terms describing “pass-through” financial activity. Substantial economic effect is another term that is commonly used in the management of partnership businesses, too vague of a reporting measure to be used as the sole description of company performance in a corporate organization, where disclosure of financial activity must be explained in detail in the interest of meeting rules to investor notice of earnings.
How Partnership Income Is Taxed
The members of a partnership firm are not considered separate from the organization by the IRS. Responsible for the individual reporting of business income in Form 1040, Schedule SE, annual tax return filing must be performed by the owners to cover the requirement of partnership. Profits and losses of the business are effectively passed through to the partners, who in turn are responsible for assuming reporting of this activity to the IRS and state tax commission or board in the state jurisdiction where the partnership is maintained if individual income tax rules apply.
Filing Tax Returns
Partnerships must file IRS Form 1065, an informational return of partnership income. This is not in lieu of individual IRS Form 1040, Schedule SE filing obligation of the partners. A Schedule K-1 must also be filed with the IRS, and with each partner, breaking down each partner's share of the business's profits and losses.
Estimating and Paying Taxes
In partnership entities, there is no employer responsible for computing and withholding income tax. Each partner must set aside tax payment per share of annual profits. Estimated income from a partnership should be the amount of tax they will owe for the year. Partnerships generally make quarterly payments to the IRS to ensure proper control.
Profits Are Taxed Whether Partners Receive Them or Not
Partnership tax payments are estimated according to "distributive share." Distributive share is the portion of profits a partner is entitled under a partnership agreement and in some cases under state law. The IRS automatically calculate taxes owed on distributive shares each year regardless of whether or not there has been a profit. Partners must pay taxes on the distributive share of the partnership's profits on a quarterly basis, minus total sales expenses. IRS guidelines to distributive shares are that partners owe income tax on the rightful share of income. Income is not actual income received, but this corresponds to the rationale that partners will claim estimated tax-deductible businesses income expenses as part of their individual tax return.
Establishing the Partners' Distributive Shares
Distributive shares are outlined in the written partnership agreement, or deemed to be present by state law. For partnerships without a written agreement, state law generally allocates profits and losses to the partners according to what is determined to their ownership interests in the business.
Special allocation of profits and losses is a condition where a partners' actual percentage of interest in the business is not the amount claimed. The IRS provides the special allocation rule to partners actively involved in running a partnership. In addition to income taxes, the IRS requires submission of a Schedule SE reporting "self-employment" taxes on all “pass-through” partnership profits received by a partner as special allocation. Self-employment taxes consist of Social Security and Medicare contributions.
Partners must pay “self-employment” tax with their regular quarterly income tax payments and typically pay twice as much as regular employees, as not matched employer contribution is made. Partners can deduct up to half of self-employment tax contribution from taxable income, thus reducing the total tax bill. The Schedule SE for self-employment is submitted once a year with a partners income tax return, while payments are made on a quarterly basis.
Expenses and Deductions
Owners of “pass-through” entities have the advantage of substantial business expense deductions from their business income. Reporting of deductible business expenses substantially lowers the profit margin on a tax return. Deductible expenses include initial start-up costs, operating expenses, product and advertising, travel expenses, as well as business-related meals and entertainment. Domestic travel expenses do not require explanation and include hotel and ground transportation. International travel expense deductions must be accompanied by a rationale for travel (i.e. conference, convention, meeting).
Get Expert Help
When planning, structuring, or controlling a “pass-through” business, a tax adviser or tax attorney can provide advice on the tax reporting process.
If a business has grown in financial size, incorporation offers an advantage over “pass-through” taxation obligation. Corporate owners pay tax only on compensation for services (i.e. salary) or stock dividends. If retained earnings are expected, owners may withhold tax on those earnings.
Inquiries about the tax obligations of “pass-through” entities, may post your legal need at UpCounsel legal marketplace. UpCounsel lawyers represent the top 5 percent attorneys in the United States, graduating from top law schools such as Harvard Law School and Yale Law School. UpCounsel attorneys have an average 14 years of legal experience, and have represented corporate clients like Google and Stripe.