What is a Pass-Through Entity?
The pass-through entity can be defined as a process by which any organization will be relieved from the double taxation burden. The entity passes its total income to the entity’s owners; therefore, taxes are calculated individually for every owner.
The reason for passing through income structure is that the owners otherwise get double taxedDouble TaxedDouble Taxation is a situation wherein a tax is levied twice on the same source of income. It usually occurs when the same income is taxed both at corporate as well as at the individual level.. First, they pay taxes on the corporate profitCorporate ProfitCorporate profit, or ‘profit after tax, is the net income received from the business after deducting direct expenses, indirect expenses and all the applicable taxes from the total revenue generated by the company during the year., and later when the profit after tax is distributed to the owners, it is double taxed as individual income.
Table of contents
Types of Pass-Through Entity
Examples of Pass-Through Entity
A manufacturing partnership firm distributes its income entirely to its partners. The firm is considered a pass-through entity. Suppose the income for the year was $40,000, and expenses to meet the business requirements were $20,000.
Now, the earnings before interest and taxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital. come to $20,000 i.e. ($40,000 – $20,000).
If the interest on the loan is $5,000, the earnings before taxesEarnings Before TaxesPretax income is a company's net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense. (EBT) come out to be $15,000. It is the firm’s income for the year after deduction, which will be distributed among the partners in a ratio mentioned on their partnership deed. Say, for example, the partners have agreed to share 50% each. Then the income will be distributed equally between each one of them. By following this method, the partners will be taxed only once in their capacity, leading to a lower tax burden.
Let’s take another example. Mr. Agnes is a sole proprietor. He is engaged in a construction business. He is married to Isabel, and now their joint income is $150,000. He plans to open an S corporation so that the entire income of the husband and wife gets clubbed. Also, they may be eligible to get a deduction of 20%. Per the general rule issued for pass-through entities, the owner will get a deduction of 20% on its income. Mr. Agnes can now claim a deduction for the entire $150,000.
- Tax Benefits: The most significant benefit of using this mechanism is that people in business can easily save on their taxes. The pass-through entity helps the business owners pass their income to them. Double taxation can be avoided using this mechanism. Owners have to pay taxes on their dividend income and the income from their businesses; thus, they are relieved from paying double taxes to the government. The government approves these mechanisms, so there are no chances of future obligations regarding the taxes on the same.
- Income gets Clubbed: The income of both husband and wife can get clubbed if the income is routed through a corporation or LLCCorporation Or LLCLLC stands for Limited Liability Company, which is a type of company in the United States corporate structure where the entity's owners are not personally liable for the entity's debts and that can also combine partnership and sole proprietorship features, whereas Corporation is macro in nature and consists of a group of companies that act as one entity and are recognized legally with a wider meaning.. The income tax will be given on the sum after clubbing.
- Deduction Available: The basic deduction of 20% on the income is available to the owners, 20% on the qualified business income.
- Income can be Diverted: If an S corporationS CorporationS corporation refers to the special status entity exempted from paying corporate tax, which allows shareholders to be taxed only once when they receive the benefits by follow-through taxation, thereby avoiding double taxation at the corporate level under a special chapter of IRS so that all the rules specified in the chapter shall be complied with. or LLC owner opts to get their business income passed through the S corporation, he can easily do it. The income will be taxed on a simple individual tax bracket for an individual and his business. The owner can arrange to get a fixed amount from this type of pass-through entity he has created. A later stage can show this as a salaried or fixed income and will pay a tax per normal tax rate, which is levied on salaried income. Using this mechanism, he will easily escape the corporate taxesThe Corporate TaxesCorporate tax is a tax levied by the government on the profits earned by a company at a fixed rate each year and is calculated in accordance with specific tax regulations. he has to pay for that income.
- Limited Liability Obligation: This type of pass-through entity’s owner has one advantage: limited liabilityLimited LiabilityLimited liability refers to that legal structure where the owners' or investors' personal assets are not at stake. Their accountability for business loss or debt doesn't exceed their capital investment in the company. It is applicable in partnership firms and limited liability companies.. It means that whatsoever happens, the assets of the owners are well protected. In case of litigation also, the owners are relieved from the claims.
- Easy Switching Options: It is very easy to switch the potions in which we would like to be taxed. Suppose we have an S corporation and plan to switch it to LLC. We can easily do it. Thus this helps in the planning of our finances as well.
- Profit Distribution System: In this mechanism, the profits or losses will be shared by the owners in their desired ratio, but in some types of pass-through entities, the distribution is restricted to the percentages of their own in that corporation. Now, this creates confusion and disagreement between the owners. Thus this becomes one of the most important disadvantages of this type of entity.
- The Complication in Registration Formalities: Saving taxes is an art that is a little bit complicated also. The registration process in this type of entity is somewhat complicated in the beginning. The government checks all the documents carefully and then gives the registration number. After getting the registered entity, the owners can switch the S corporation to LLC or vice Versa.
- Rules Changes from Each State to State: The rules are different in all states and countries. The owners are not allowed to use the rules as a whole. They have made their corporation’s rules per the state, which can be a bit complicated. Moreover, whenever they want to migrate to another state or country, they again have to consider establishing the rules; this is the biggest problem with the pass-through entity. Even they have to make a point while transacting with other states and countries.
The concept of a pass-through entity is very structured. The entity helps us avoid double taxation each time the owner pays tax as an individual and corporate taxpayer. This mechanism is ingenious for those who can use it carefully. The cons of this mechanism should also be considered while planning to opt for such a scheme of business structureBusiness StructureBusiness structure is the legal framework adopted by a company to execute business activities in compliance with the corporate rules and regulations. An organization can be a sole proprietorship, partnership, limited liability company or corporation..
This article has been a guide to what is a pass-through entity and its definition. Here we discuss types and examples of the pass-through entity and its advantages and disadvantages. You can learn more about accounting from the following articles –