It’s common for businesses to seek safe, effective, lawful ways to minimize their tax liability. A high tax bill can throttle the potential for a business to thrive, grow, and innovate. If your business operates as a pass-through entity, it may be easier to preserve funds, pay yourself in the early stages of your business, and grow to your full potential.
This is what businesses need to consider when choosing a structure and how Mosey can work to keep businesses tax-compliant.
What Is a Pass-Through Entity?
A flow-through entity, also called a pass-through entity, is a business that distributes its earnings to its owners, members, or shareholders directly rather than to the entity itself. Because the entity itself doesn’t have an income, the earnings are reported on an annual income tax return by people who receive a share of the profits.
All income is divided and reported, and appropriate taxes are paid. There is no legal requirement for every type of business structure to pay corporate taxes, as the requirement is specifically written into the rules for applicable structures. There are numerous business structures intended to be utilized as pass-through entities.
What Is Double Taxation?
Business earnings can be taxed multiple times from the moment they become business income until they eventually become someone’s paycheck. Money gets whittled down in incremental percentages until a substantial portion of the money is converted into taxes throughout its lifestyle.
Business owners who do not use a pass-through structure will have to pay taxes twice, which is known as double taxation. They’ll pay a flat corporate tax rate of 21 percent in addition to taxes on the earnings they personally receive. By bypassing the corporation, earnings are only taxed once as individual income.
What Types of Entities Can Be Pass-Through Entities?
Several types of business entities are generally treated as pass-through entities unless they specifically elect to be treated otherwise.
There is no federal entity-level tax for these types of pass-through businesses:
- Sole proprietorship
- Limited partnership (LP)
- Limited liability partnership (LLP)
- General partnership
- Limited liability company (LLC)
- S corporation
C corporations are not pass-through entities by default but may be able to elect to become pass-through entities. All C corporation profits are subject to the 21 percent corporate flat tax before profits can be distributed, and their share of income will be taxed again.
How Does a Business Become a Pass-Through Entity?
Most business structures are treated as pass-through entities by default. The only type of business entity that isn’t automatically regarded as a pass-through entity is a C corporation. Every type of LLC or partnership, as well as sole proprietorships, will be treated as a pass-through entity by default.
Single-member LLCs are regarded as sole proprietorships because a sole proprietor essentially runs them, and multi-member LLCs are treated as partnerships and subject to partnership taxes.
S corporations are slightly different. An S corp isn’t technically a business structure — it’s a tax classification. All businesses have the option of electing to be taxed as an S corporation if they meet the necessary criteria. Many flow-through entities choose to be taxed as an S corporation for its potential tax benefits.
What Is an S Corporation and How Does It Work?
An S corporation is a tax status election that most corporations can make. An S corporation is a domestic corporation with no more than 100 shareholders or members, all of which must be U.S. citizens or permanent residents. Nonresident aliens, other businesses, and many types of entities are ineligible to act as shareholders.
Profits are divided and passed through every member of the corporation. You can utilize every tax credit and tax deduction you’re eligible to use on your personal income tax return for your share of income. Up to 100 individual income tax returns will be filed, and each person will pay income tax or receive a refund if eligible based on tax filing requirements.
A C corporation can elect to be taxed as an S corporation in order to become a pass-through entity. Entities that are already considered pass-through entities can elect to be taxed as an S corporation to create more substantial tax savings on self-employment taxes.
Corporations that elect to be taxed as S corporations can prove eligibility and file a separate tax election form with the IRS stating their preferred tax status.
What Is the Difference Between a Disregarded Entity and a Pass-Through Entity?
A pass-through entity is a situation where a business is recognized but is primarily considered to be the individuals who run the business. A disregarded entity is a situation where the business is only one person. Single-member LLCs and sole proprietorships are always disregarded entities.
The IRS ignores that the income was generated through a business and attributes all business financials to the sole individual utilizing the business to make a profit. Individuals can make estimated quarterly tax payments according to a schedule to stay ahead of their obligations. The quarterly estimated payments are usually based on similar income in previous years but may be based on educated conjecture during the first year a business operates.
In the case of single-member LLCs, a disregarded entity can have employees. Those employees make their required tax contributions from their paychecks, and single-member LLC managers will likely still be required to pay employment taxes.
What Are the Pros and Cons of Pass-Through Entities?
Many businesses enjoy their status because of the potential pass-through entity tax savings. Eliminating the potential for double taxation can increase personal profits and salaries. The potential downside of a flow-through entity occurs when it’s time to reinvest in the business, which can lead to the taxation of investments.
The Pros of Pass-Through Entities
The tax treatment is the most apparent benefit of electing to be taxed as a pass-through entity or an S corporation. The corporate tax is completely removed from the equation, meaning that profits are only taxed once. Members will still pay taxes but will do so at a personal income tax rate. They’ll also be able to take as many personal deductions as they’re eligible to take.
The Cons of Pass-Through Entities
The most significant downside of a pass-through entity is how income must be reported, regardless of how it’s utilized. A single-member LLC who decides not to collect a substantial paycheck from their business in favor of reinvesting most of the profit into business growth would still be taxpayers on the money that they didn’t personally keep.
This can put younger businesses at a disadvantage. You aren’t allowed to ignore reinvestment for tax purposes or write it off the way you would if you weren’t a pass-through entity. Some businesses elect not to be taxed as a pass-through entity until they’ve built themselves to a point where they’re comfortable with their upward trajectory for this very reason.
If you are a business owner concerned with these implications, there may be suitable solutions to this dilemma. You can consult with a local business tax professional about your plans and the options available to you before you make any major decisions regarding your tax classification.
How Does Being a Flow-Through Entity Affect State Tax?
Your tax designation primarily applies for federal income tax purposes. Being a flow-through entity won’t exempt you from paying any taxes you may owe to your state. States make their own laws and set their own rates for corporate income tax and state income tax.
Depending on where your business is registered, you may have to pay a flat or tiered tax rate depending on your business income. Many states have implemented tax cuts for businesses, hoping that reducing the overall tax burden for entrepreneurs and startups will help local economies thrive.
You’ll need to consult local laws for more information regarding state tax policy. Requirements can vary significantly based on locale.
How Mosey Can Help With State Tax Compliance
Tax compliance is a serious concern for businesses of all sizes. Your ability to meet your tax obligations with your state and local government is what determines your ability to operate and grow.
Mosey’s compliance automation solutions can help you keep track of state and local tax compliance (as well as many other state business compliance issues) through one simple dashboard. Schedule a demo with Mosey to learn how we can help your small business stay on the right track.
