Pass-through entities, fundamental to small business operations and prevalent across the U.S., directly pass income to owners or members, avoiding corporate income tax at the entity level. Partnerships and S-corporations, allow income to flow to individuals who then pay personal income taxes on their share, distinguishing them from traditional corporations subject to double taxation. The Tax Cuts and Jobs Act further incentivizes this structure by offering a Qualified Business Income Tax Deduction, reducing taxable income for eligible owners by up to 20%. This taxation framework supports the principle of single taxation and is pivotal for the majority of U.S. businesses aiming to minimize tax liabilities while ensuring compliance with both federal and state regulations.
I. Understanding Pass-Through Entities
Definition of pass-through entities
In the realm of business entities, understanding pass-through entities is crucial. Pass-through entities, including S Corporations and partnerships are defined by their characteristic of not paying income taxes directly; instead, the income passes through to the owners, who then pay taxes on their personal income tax forms. Within this framework, there are several common types:
- Partnerships: Businesses owned by two or more individuals who share profits and losses. Partnerships file an entity-level tax return (Form 1065), with each partner reporting their share of income on Schedule E.
- S Corporations: These entities, limited to 100 shareholders, pass profits and losses through to shareholders who report them on Schedule E. S Corporation owners are required to pay themselves “reasonable compensation,” subject to FICA tax.
Understanding these types of pass-through entities is essential for navigating the tax implications and benefits associated with each structure.
II. The Impact of Tax Cuts and Jobs Act (TCJA) on Pass-Through Entities
The Tax Cuts and Jobs Act (TCJA) of December 22, 2017, brought significant changes affecting pass-through entities, notably through the imposition of a $10,000 cap on state and local tax (SALT) deductions for individual taxpayers. This limitation, effective since January 1, 2018, and scheduled to last until the end of 2025, prompted various states to introduce workaround initiatives, such as employment or charitable contribution-based strategies. Connecticut notably pioneered a pass-through entity (PTE) level income tax to counter the TCJA’s SALT cap, obligating entities to pay taxes on Connecticut-sourced income. The IRS later issued regulations confirming the permissibility of such PTE workarounds, prompting many states to adopt similar programs.
III. Making the Pass-Through Entity Election
Establishing a flow-through entity involves selecting between an LLC, S corp, or sole proprietorship, followed by several steps in the tax filing process:
- Calculate Taxable Business Income: Determine the taxable income before owner’s compensation.
- Allocate Income: Divide taxable income based on ownership percentages; for instance, if you own 100% of the business, you’re taxed on the entirety of the income.
- Report Income: Report your share of the business income on tax Form 1040.
- Pay Taxes: Pay taxes based on this personal taxable income.
Different types of business entities may require additional tax forms; for instance, S corps need to provide IRS Form 1120-S. Most flow-through entities, including many LLCs, are subject to IRS self-employment tax, typically 15.3% of earnings, along with state and local taxes where applicable.
Flow-through entities address the issue of double taxation, where corporations and shareholders are taxed on the same income twice. Corporations pay taxes on earnings, and when dividends are distributed to shareholders, they’re taxed again. To avoid this, pass-through entities treat business income as the income of investors or shareholders, who pay taxes on it as ordinary income at their personal tax rates.
Potential benefits and drawbacks of electing pass-through status.
Choosing to elect pass-through status for your business entails weighing potential benefits and drawbacks.
Benefits of Pass-Through Taxation:
- Avoidance of Double Taxation: Pass-through taxation prevents double taxation, unlike traditional corporations where income is taxed at both the corporate and personal levels.
- Eligibility for QBI Deduction: Owners of pass-through entities may qualify for a qualified business income (QBI) deduction of up to 20%.
Disadvantages of Pass-Through Taxation:
- Taxation on Unrealized Income: Owners may be taxed on income they didn’t receive, as pass-through entities can’t defer taxes on profits intended for reinvestment.
- Potential Higher Tax Burden: Despite avoiding corporate taxes, owners may face higher self-employment taxes and personal income taxes, leading to a potentially higher overall tax burden.
Furthermore, while pass-through entities benefit from single taxation, it’s essential to recognize the possibility of higher personal tax liability and the inability to defer taxes on reinvested profits, making careful consideration crucial when making the pass-through entity election.
CONCLUSION
The landscape of pass-through entity taxation presents both opportunities and challenges. Staying abreast of legislative changes and engaging with tax professionals can help navigate these complexities, ensuring that businesses maximize their tax benefits while adhering to compliance requirements. The shift towards pass-through entity structures underscores the evolving nature of business taxation in the U.S., highlighting the importance of informed decision-making in the pursuit of financial optimization and growth.
