Pass Through Entity

What is a Pass-Through Entity?

The pass-through entity can be defined as a process by which any organization will be relieved from double taxation burden. The entity passes its total income to the entity’s owners and therefore, taxes are calculated on the individual basis on each and 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.read more. 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.read more, and later when the profit after tax is distributed to the owners, it is double taxed as individual income.

Types of Pass-Through Entity

Types-of-pass-through-entity

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Examples of Pass-Through Entity

Example #1

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, 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.read more 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.read more (EBT) comes out to be $15,000. It is the income of the firm for the year after deduction, and this 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 individual capacity, leading to a lower tax burden.

Example #2

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 comes to $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%. As per 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.

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Advantages

Disadvantages

  • 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 a confusion ad 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 begging. 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 vise 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 rues as a whole. They have made their corporation’s rules as per the state, which can be a little bit complicated. Moreover, whenever they want to migrate to some other 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 as well.

Conclusion

The concept of a pass-through entity is very structured. The entity helps us avoid the double taxation each time the owner pays tax as an individual and also as a 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.read more.

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 along with advantages and disadvantages. You can learn more about accounting from the following articles –