Pass-Through Sole Proprietorship: Everything You Need to Know
A pass-through sole proprietorship is a partnership, an LLC, or an S corporation that is filing for a federal income tax.10 min read
Updated October 30, 2020:
A pass-through sole proprietorship is a partnership, an LLC, or an S corporation that is filing for a federal income tax. What is a pass-through entity specifically? In summary, a pass-through entity can be described as a specialized business structure with the goal of reducing the burden of double taxation.
Because these pass-through entities do not contribute to a corporate income tax, corporate income is instead split between the company's owners. Then, taxes are imposed at the level of each distinct owner, alleviating the overall imposition of an individual owner. Accordingly, the business owner files their individual pass-through corporate taxes through his or her individual income tax form. This is a benefit to corporate owners, as corporate businesses are levied with steep income tax rates that sometimes exceed 50 percent, depending on the state. However, pass-through businesses enjoy a single layer rate of tax on their profits, as opposed to the double layer of tax that C corporations must endure.
Since 1980, pass-through businesses have almost tripled in number. Meanwhile, the rate of C corporations has lessened, likely due to the heavy tax burden. A substantial portion of today's pass-through companies files income taxes at high individual rates, allowing pass-through businesses to earn a higher net income when compared to dwindling C corporations.
How Does a Pass-Through Sole Proprietorship Work?
Consider this example. Company X is registered as a pass-through entity. When filing a tax return, Company X lists its two owners, Dick and Jane, as splitting half the company. Fifty percent to Dick, and 50 percent to Jane. To accommodate their pass-through entity status, Company X delivers Dick and Jane a Schedule K-1 form from the Internal Revenue Service (IRS), which lists the appropriate portion of Company X's pass-through taxable income. Next, Dick and Jane respectively file their own personal income tax return, reporting $200,000 worth of income.
Here, it's worth noting that even if the $400,000 of net income isn't distributed to Dick and Jane respectively, Company X still allocates that sum to its two owners. Think of it this way: consider that the amount of taxes owner Jane must pay amounts to 20 percent of that $200,000 in the year 2015. Applying that logic, Jane must pay $40,000 to the IRS, even if Company X didn't distribute that net income to Jane in 2015. In fact, Company X may not distribute those funds until 2017. Nevertheless, Jane has a legal responsibility to pay the $40,000 in question, even if those funds weren't received in 2015 or 2016.
When Company X suffers a loss, those are also passed along to Company X's owners, since Company X is a pass-through business. However, owners Dick and Jane can only deduct the amount of their original investment.
Lastly, some examples of what can be considered a pass-through entity include the following:
- A sole proprietorship
- An S corporation
- A master limited partnership (also called an MLP)
- A limited liability partnership (also known as an LLP)
- A limited liability company (commonly known as an LLC).
Why Do Pass-Through Sole Proprietorships Matter?
A pass-through sole proprietorship demonstrates a specialized tax status, which effectively dissolves the burden of double taxation. This limits the effects on a company and its shareholders, instead of deriving taxes only through a company's owners.
Though removing the pricey burden of double taxation is one advantage of a pass-through sole proprietorship, it doesn't necessarily mean that organizing a company in such a way is the wisest option. Restrictions are often placed on certain benefits and fringe perks, and rules exist on the number of owners for a company filing this way.
What About Sole Proprietorship in Freelancing?
Plenty of freelancers began doing projects on the side as a way of boosting their monthly take-home, before ultimately transitioning to freelance work full time. A freelancer is considered an individual if he or she has not incorporated his or her business. To report income as a sole proprietor freelance worker, use schedule C on the IRS's 1040 tax form.
Are Sole Proprietors Taxed?
Sole proprietors have to report their losses, as well as their total business-related income when filing a personal tax return. As a sole proprietor, your business isn't taxed separately. This practice is called “pass-through” taxing, since the profits of your business go directly to you.
How to File a Tax Return as a Pass-Through Entity
The most significant difference between filing your income tax return as a sole proprietor and reporting the wages you earned at a traditional job is that you have to list your business's loss and profile data on the Schedule C form from the IRS. This form goes hand in hand with Form 1040.
As a sole proprietor, your business's profits will be taxed according to a figure derived from your total profits after deducting expenses. No matter how much you did or did not withdraw, you are responsible for tax payment as your business's sole proprietor. This means that even if you put away money in your business's account come December (perhaps to prepare for future expansion or costs), that money is ultimately taxable.
It's worth noting that, like a traditional business, you should deduct your expenses. As a sole proprietor, you can expense a significant portion of any funds spent in the name of your business, including the cost of operation, any marketing costs, expenses related to travel, and even food or entertainment that were related to pursuing profit for your business. Specific startup costs can also be written off as expenses, as well as any business-related assets or products necessary to run and operate your business.
It is important to keep proper records of these business-related expenses that demonstrate the difference in spending between your business and your personal life. A solid method is to maintain distinct checkbooks related to your personal life's costs and your business's costs. Pay for all your business-related expenses from a linked business-only account.
As a sole proprietor, you don't have the benefit of a traditional employer who can withhold your taxes through your biweekly paycheck. That means that it is your responsibility to put aside appropriate funds to pay taxes related to your work during the fiscal year. As a sole proprietor, make an educated guess on how much you'll owe in taxes annually and then pay out quarterly fees to the IRS and your state (if required at the state level).
If you are a sole proprietor, you are required to contribute to Social Security and Medicare institutions. These combined tax fees are considered a self-employment tax.
Similar to a payroll tax at a traditional business, self-employment taxes are contributed by sole proprietors when reporting income tax. While employees must only cover 50 percent of these pay-in costs (their employer matches the other half), a sole proprietor covers the whole amount on his or her own. It's important to note that a sole proprietor can deduct half of this associated cost.
At the federal level, the rate of the self-employment tax amounts to 15.3 percent. This figure is broken down by 12.4 percent allocated to Social Security (though there is a yearly income ceiling built-in where this portion of the tax ceases to apply), and the remaining 2.9 percent to Medicare (this portion has no associated income ceiling).
The IRS's website has additional information on the yearly ceiling for Social Security payment. Taxes related to self-employment are to be reported on the form schedule SE, submitted annually in conjunction with the 1040 form and the Schedule C form.
Incorporate Your Business and Reduce Your Taxes
When it comes to income taxes, a corporation and its owners are considered unconnected entities. Corporation owners aren't responsible for paying their company's annual earnings if they have not received that money as compensation or dividends (in the form of a salary or set of bonuses). It is the responsibility of the corporation to pay taxes on all its remaining profits.
If an owner of a corporation decides to leave a portion of profits in the business at year-end, he or she benefits from a diminished corporate tax rate, up to the initial $75,000 in remaining profits.
Today's corporate tax rate amounts to just 15 percent out of the first $50,000 worth of profit, and just 25 percent on the additional $25,000 of profit. Corporations are generally taxed at a lower rate than what its shareholders likely pay in personal income taxes.
As an example, let's say you own a company specializing in web design and you have a goal of building up a monetary reserve in order to purchase new equipment in the future. Or, perhaps your manufacturing company has a goal of accumulating additional inventory to account for an upcoming expansion. This means you likely need to leave profit money in your account at year-end. Let's imagine this amount comes to roughly $50,000 in profits. As a sole proprietor, these profits (considered “retained”) are going to be taxed at a rate related to you as an individual, likely surpassing 25 percent. However, if you instead choose to incorporate your business, those retained profits would be taxed at the lower 15 percent corporate tax rate.
Note that corporate taxes are complex when compared to sole proprietor pass-through taxes. The few thousand dollars' worth of savings from the scenario above may not outweigh the hassles of incorporating.
Increase in Pass-Through Businesses
Since the famous Tax Reform Act dating back to 1986, the U.S. now boasts a higher number of pass-through businesses, which effectively lowered the income tax rates for individuals.
Types of Entities
The status of a sole proprietorship doesn't protect against personal liability suffered as a result of business-related activities. This is a sticking point, especially if freelancing constitutes your full-time work and you might have more liability exposure than when you freelance part-time.
Which Is Better for Taxes?
To determine which status is best for filing taxes, focus on the ramifications of registering as an LLC versus registering as an S corporation, which is the most common option when full-time freelancers are considering registering as a business.
What Do Pass-Through Businesses Pay in Taxes?
Tax-wise, the idea of a pass-through business is to “pass” a business's income and losses to its owners. By that logic, pass-through businesses are subject to the same marginal tax rate as an individual. These rates begin at 10 percent on the first $9,075 of income that is taxable. This adjusts to $18,150 if the pass-through entity is married and files jointly. These rates rise again to 39.6 percent if the taxable income in question exceeds $406,750.
Sole proprietors and partnerships pay self-employment (also called SE) tax. Self-employment taxes are levied on self-employment related income, funding Social Security and Medicare to equate with what traditional wage-earners contribute to payroll taxes.
Pass-through businesses and C corporations pay taxes differently. C corporations are taxed at the 39.1 percent (combined) federal and average state tax rates.
Alternatively, pass-through entities that face the highest marginal tax rate (combined with its home state's average rate) endure an average 47.2 percent tax rate. This is compared to the C corporate income (at the shareholder level) which amounts to an average total rate of 56.5 percent.
A Pass-Through Business Earns Higher Than a C Corporation
As the amount of pass-through entities increase, they continually earn a higher net business income collectively, when compared to a grouping of traditional C corporations.
Combined, the net income of all sole proprietorships, S corporations, and partnership back in 1980 amounted to $188 billion, while the total net income of C corporations was $697 billion. However, in 1998, pass-through entity income skyrocketed by 340 percent up to $829 billion, which finally overtook the net income of C incorporations, which amounted to $773 billion.
Comparing Employment Rates
The majority of the private sector's workforce is self-employed or works for a pass-through entity. Considering that pass-through businesses earn a higher net income than C corporations, it makes sense that there are a greater number of pass-through entity employers. Census data in 2011 shows that pass-through businesses accounted for more than half (55.2 percent) of private sector employment.
Pass-Through Businesses are Smaller Than C Corporations
C corporations still contribute to employment in a major way, likely because they are so much larger than the average pass-through business. C corporations concentrate employment at large firms. For instance, in 2011, 72.3 percent (translating to 38 million people) of workers at C corporations were employed by firms with more than 500 employees. Meanwhile, 8.9 percent (or 4.7 million individuals) worked at firms with employee numbers between 100 and 500.
Employment at pass-through businesses is distributed among a range of smaller firms. It's important not to conflate pass-through entities with small businesses, as 33.6 percent of these count as self-employment or small firms hosting between one and 100 employees.
According to census data from 2011, 27.5 percent (or 18.1 million employees) worked at firms larger than 100 employees. 15.9 percent (or 10.3 million employees) worked at large firms home to more than 500 employees.
Most of the private sector workforce (in 48 states) is generated by pass-through businesses. Pass-through employment in the U.S. varies by state, according to information from the census bureau. More than 60 percent of business employment in eight states was generated by pass-through employment: Vermont (63.1 percent), Idaho (64 percent), Maine (62.4 percent), Montana (67.9 percent), Rhode Island (60.6 percent), Wyoming (61.8 percent), South Dakota (64.7 percent), and North Dakota (60.5 percent). Pass-through entities account for a large number of private sector payroll, as well.
The Service Sector and Pass-Through Businesses
While pass-through businesses employ individuals across industries, service sector industries have more significant shares of pass-through employment compared to corporate employment.
Manufacturing, Trade, and C Corporations
Conversely, jobs in manufacturing and trade are ruled by C corporate employment.
Pass-Through Business Advantage of High-Income Earners
High-income earners report the most income through pass-through businesses Since the income of a pass-through business is taxed at an individual level, the distribution of pass-through income among individuals helps paint a picture of the overall effects of individual marginal tax rates.
If you need help with a pass-through sole proprietorship or any other type of corporation, you can post your legal need 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 on behalf of companies like Google, Menlo Ventures, and Airbnb.