Pass-Through Taxation: What You Need to Know

Most US businesses have a pass-through taxation structure: they are not subject to corporate tax. Instead, they have their income “pass through” to their owners to be taxed on their individual income tax returns. 

Pass-through businesses have simpler filing and a lower tax rate than C corporations because they avoid double taxation. Pass-through business owners must pay self-employment taxes, however, in addition to state and local taxes. C corporations are eligible for some tax breaks that pass-throughs do not qualify for, although pass-through entities may qualify for a special deduction under a tax law that took effect in 2018. 

Taxation is not the only factor to consider when selecting a business structure. Not all pass-through businesses enjoy limited liability protection, and unincorporated businesses may face limitations with growth and financing. 

Types of Pass-Through Business Entities 

According to the Internal Revenue Service (IRS), a pass-through entity is a business that passes its income, loss, deductions, or credits to its owners. It does not typically have an entity-level tax liability. Many entities offer options to enjoy pass-through taxation; however, how an entity accesses this option varies depending upon the type of business. 

  1. A sole proprietorship is the default structure of a business owned by a single taxpayer, such as a freelancer or independent contractor. Sole proprietorships are the most common type of pass-through entity. The owner of a sole proprietorship reports business income on Schedule C of a 1040 tax return. 
  2. A partnership has multiple owners. The owners can be individuals or other businesses. Partnerships make up around 11 percent of all pass-through business entities. They file an entity-level tax return, but each partner’s business income, which is distributed according to the partnership agreement, is reported separately using Form 1065. 
  3. A limited liability company (LLC) has a flexible structure that allows it to be taxed as different pass-through entities, as well as a C corporation. An LLC with one member/owner is taxed as a sole proprietorship by default, while an LLC with more than one member/owner is taxed like a partnership. An LLC can also elect to be taxed as a corporation by filing Form 8832. 
  4. A corporation, sometimes referred to as a C corporation, is subject to double taxation as a default. That is, corporate income is taxed once at the corporate level through the corporate income tax and a second time at the individual level through the individual income tax on capital gains and dividends. However, C corporations may elect to receive a special pass-through designation as an S corporation. 

About the S Corporation Tax Election

An S corporation is a tax election limited to US citizens and businesses with up to 100 shareholders. S corporations file federal income taxes using Form 1120-S. Each shareholder reports their business profits and losses. About 13 percent of pass-through businesses are S corporations. LLCs and corporations may elect to be taxed as pass-through entities by filing Form 2553.

Avoiding double taxation is a major incentive for businesses to organize as pass-through entities and explains why about 95 percent of US businesses are pass-throughs. These types of companies employ more than half of all private-sector workers and account for around 40 percent of all private-sector payroll. 

High-income taxpayers earn the majority of pass-through business income. About 45 percent of pass-through income is earned by taxpayers who make $500,000 and over. Pass-through status lets these taxpayers avoid double taxation, but their business income could place them in a higher tax bracket. 

To take the sting out of pass-through business income taxes, owners may be able to exclude up to 20 percent of qualified business income (QBI) from federal income tax using the Qualified Business Income Deduction. The pass-through deduction was added through the Tax Cuts and Jobs Act (TCJA) of 2017. The law’s details are complex, though—not all businesses qualify for the QBI deduction, and determining eligibility requires a multistep approach. 

Disadvantages of Pass-Through Status

Not having to pay taxes twice on business income is a major benefit of pass-through entities, but the tax picture is more complex than double taxation versus single taxation. 

  1. C corporations do not have to pay taxes on retained earnings or profits that are reinvested in the business. Flow-through entities, on the other hand, typically must pay taxes on all earnings, whether they are retained. As a result, flow-through businesses may have more of an incentive to distribute profits as dividends to owners, rather than use them to build the business. 
  2. C corporations can deduct fringe benefits—things like health insurance, paid time off, and commuter benefits—from their taxable income. Flow-through entity owners, however, may not write off fringe benefits. 
  3. C corporations might be able to write off more charitable deductions than pass-through businesses. C corporations can generally make tax-deductible charitable contributions up to 10 percent of their taxable income. Pass-throughs can deduct charitable contributions as well, but only if they itemize their deductions. 
  4. C corporations can issue an unlimited amount of stock, making them much more attractive to investors. Among pass-through entities, only S corporations can issue stock, but only up to 100 shareholders, and only one class of stock.
  5. Not every type of pass-through entity offers limited liability. Starting a pass-through entity, especially a sole proprietorship or general partnership, is relatively simple. These types of businesses are created by default, without their owners having to file any paperwork with the state. Yet unlike a corporation or LLC, an unincorporated business is not a legal entity separate from the owners. Unincorporated businesses have unlimited liability. In the event of a bankruptcy or lawsuit, creditors can go after the personal assets of the owners. 

Which Structure Is Right for Your Business? 

Choosing the proper business entity structure involves balancing several factors. Owners are in business to make money. Most want to earn—and keep—as much income as possible. Federal taxes are just one piece of the taxation puzzle. State and local business taxes must also be considered to get a complete picture of a business’s tax rate. In addition, the tax breaks that you qualify for may change as your business grows and becomes more complex. 

A simple business structure can make sense early on when you are effectively self-employed, have no employees, and face little exposure to liability. But at some point, it could make sense to transition a sole proprietorship or general partnership into an LLC, elect to have your LLC taxed as a corporation, or change your S corporation to a C corporation. There can be many different reasons to change an existing business structure, including not only tax considerations, but also limited liability protection, raising money from outside investors, succession planning, and hiring employees.

Before selecting a business entity, you should discuss the issues with an attorney. Once we learn more about your business, financials, and goals, we can explain your options from every angle so you can make an informed, confident decision. Contact our office to set up an appointment today. 

If you reside in Foley, AL or Gulf Shores, AL, King & King Law Firm is here to assist you with your business law needs. Our team is dedicated to providing personalized and comprehensive legal services to ensure your business is set up for success. To learn more about our services, visit our Business Law page.

For additional information on estate planning and other legal services, please visit our Estate Planning and Probate page. To learn more about our team, visit the Our Team page. If you are planning your small business succession, check out our How to Plan Your Small Business Succession blog.

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