What Are Pass-Through Entities and Sole Proprietorships?

Pass-through entities and sole proprietorships are considered the dominant business structure in the US, but what do these terms really mean? How do they pay taxes to the US government? 

This blog will walk you through the pass-through structure and taxation, from the definition, types, and pros and cons of this business structure. 

What are pass-through entities and sole proprietorships?

A pass-through entity is a corporate structure in which taxation on the business income is immediately passed on to the shareholders to prevent duplicate taxation. Organization owners and shareholders under this model are taxed on the individual income earned by the company and do not have to pay extra company tax for managing the company.

Pass-through entities file more tax returns and report more business income than C corporations. Pass-through entities are not subject to corporate income tax and instead report their income on their owners’ individual tax returns.

Sole proprietorships, partnerships, limited liability companies (LLCs), and S-corporations are the most typical examples of pass-through entities. We’ll go over each of them in more detail below.

Types of pass-through entities

The most excellent part about operating a pass-through organization is that business owners have many alternatives. Here are the four different types of pass-through entities to help you better understand why you should or shouldn’t use each one.

Sole proprietorships

Sole proprietorships are the most popular type of pass-through entity, as they are the default choice for most independent contractors or freelancers. This type of business is typically easy to establish. However, sole proprietors have limited economic and accounting safeguards.

This form of pass-through entity is appropriate if you are a new business owner who is just starting up on your own. You can convert to a different model when hiring people or collaborating with other persons and groups.

Sole proprietors use Schedule C to report their business’s income or loss and determine their taxation. 

Partnerships

This type of pass-through entity is commonly used to incorporate larger micro-businesses than sole proprietorships. Partnerships are controlled by two or more people and require formal incorporation and ownership rights percentages. 

You can consider electing your business as a partnership if your company has numerous owners but isn’t large enough to be a corporation.

Limited Liability Companies (LLCs)

There are two kinds of limited liability companies (LLCs): Single-Member LLCs and Multi-Member LLCs. 

Single-Member LLCs pay their taxes in the same way as sole proprietorships, whereas Multi-Member LLCs pa in the same way as partnerships. Owners of Single-Member LLCs file their income taxes with Schedule C, Schedule E, and Schedule F, whereas associates in Multi-Member LLCs file Schedule K-1, which reflects their share of corporate profits on Form 1065.

S corporations

S corporations file their company taxes on Form 1120-S, but their revenue is immediately passed to the stakeholders and investors, who report them on Schedule E

Owners must pay “appropriate compensation,” taxed under the Federal Insurance Contributions Act but are not obligated to pay SECA tax on their profits (FICA)

Advantages and disadvantages of pass-through entities

It is advisable to investigate the benefits and drawbacks of pass-through entities to understand before electing your business as a pass-through entity.

Advantages of pass-through entities

  • Tax breaks: Pass-through entities help enterprises minimize multiple taxes by classifying net profit as individual income.
  • Simple set-up process: Several pass-through entities (including sole proprietorships and partnerships) have very few service charges and registrations, making them very simple to set up.
  • Equitable tax structure: By categorizing corporate income as personal income, owners in higher tax brackets will shoulder a more significant percentage of the tax burden.
  • Deductible losses: Owners of a pass-through organization can claim losses sustained by their firm to decrease their personal taxable income.

Disadvantages of pass-through entities

  • Stock restrictions: S-corps are the only kind of pass-through corporation that can issue stock. They are restricted to 100 investors and one form of stock, which may make raising funds from investors more challenging.
  • Fringe benefits tax: Fringe benefits (such as health insurance, stock options, and vehicles) are income for C-corps but not employees. Pass-through entities are not eligible for this benefit. However, there are limited exceptions for medical insurance. Therefore fringe benefits may be taxed.
  • Income tax on unreceived income: Even if the money stays in the bank account, shareholders of pass-through organizations must pay tax on business revenue (instead of being distributed to the owners).

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Which of These 4 Business Structures Is Best for Your New Business Idea?

One of the first things to consider when starting a business is to determine the legal structure for your business. Your business structure will influence day-to-day operations, liability obligations, and how your business is taxed. Therefore, you should choose a business structure that provides you with both legal protections and benefits.

There are four common business structures: sole proprietorship, partnership, corporation, and limited liability company. In today’s article, we’ll discuss the basics of each business structure along with its advantages and disadvantages so you can choose one that fits your circumstances.

1. Sole proprietorship

A sole proprietorship is the simplest business structure, with one person in charge of the company’s day-to-day operations. For entrepreneurs who wish to test their business idea before creating a more formal company, sole proprietorships are a good option.

Sole proprietorships don’t have their own legal entity, which means your business assets and obligations are undetached from your personal ones. For example, the profits of the sole proprietorship flow directly to its owner. And as you’re the only one who established the business, it’s obvious that the income will go into your pocket. 

The same rule will apply to your liability obligations which means you’re personally responsible for your company’s liabilities. This, on some occasions, could place your assets at risk, as they could be seized to satisfy a business debt.

There are several advantages when you structure your business as a sole proprietorship. Sole proprietorships are inexpensive to set up, and when running the business there are minimal fees (such as business taxes and operating license fees). Also, you may be eligible for tax deductions, such as health insurance. Another plus is that this type of business doesn’t require activities such as shareholder meetings, nor do you need to hold voting or election of directors.

On the downside, it’s often difficult to raise capital for sole proprietorships. This is because as a sole proprietor, you have no stock to sell, not to mention that banks and credit unions are hesitant to lend to sole proprietorships. As a result, you may heavily depend on your financing sources, such as savings, home equity, or family loans.

When it comes to filing taxes, the process is easy to follow. Because a sole proprietorship doesn’t exist as a separate legal entity from its owner, you’re not required to file separate income tax forms. In the US, all you have to do is fill in the personal income tax return, Form 1040, and attach it along with Schedule C, a report of profit or loss from a business. 

2. Partnership

A partnership is a form of a business structure owned and operated by several individuals. This is the simplest business structure with two or more owners. Partnerships are considered a suitable option for businesses with multiple owners or professional organizations (such as attorneys) looking to test their business idea before establishing a more formal company.

Partnerships come in two varieties: limited partnerships and limited liability partnerships. In limited partnerships, there’s only one general partner with unlimited liability and several other partners with limited liability. As a result, the general partner operates the business and assumes liability for the partnership, while the limited-liability partners have little control over the business and aren’t subject to the same liabilities as the general partner. This will be stated in a partnership agreement.

Limited liability partnerships are similar to limited partnerships, except that all partners who join to form the business have limited liability. Each partner in a limited liability partnership is protected from obligations owed to the partnership, and they aren’t liable for the activities of other partners.

The biggest advantage when forming your business as a partnership is the tax treatment your business enjoys. A partnership doesn’t pay tax on its income but passes through any profits or losses to the individual partner’s tax returns. When tax season in the US comes around, the partnership files a tax return Form 1065 that submits it to the IRS. Along with that, each partner fills in Schedule K-1 of Form 1065 to report their share of income and loss.

However, partnerships also have disadvantages, such as complicated paperwork when registering the company. Besides, if any disagreements occur between the partners, it would slow down the business’s operations. 

3. Corporation

Corporations are more complex than the other two business structures above. A corporation is an independent legal entity, separate from its owners. Therefore it often comes with more regulations and tax requirements.

In the US, there are two main types of corporations: C-corporations and S-corporations. A C-corporation is a legal entity independent from its owners, while an S-corporation can have up to 100 shareholders and operates somewhat similarly to a partnership.

The most significant advantage for a corporation is its liability protection to each shareholder. Because a corporation’s debt isn’t considered its owners’ debt, forming your company as a corporation won’t put your personal assets in danger. Another plus is the ability to raise capital. A corporation can sell stock to raise funds. 

One drawback of corporations is that they are subject to more requirements, such as meeting, voting, and the election of directors. Also, it’s more expensive to set up a corporation than a sole proprietorship or partnership.

When it comes to taxes, a corporation is subjected to pay both federal and state taxes. At the same time, earnings distributed to each shareholder in the form of dividends are taxed on their personal income tax returns. In other words, owners of a corporation may pay a double tax on their business’s earnings.

4. Limited liability company

A limited liability company is a hybrid business structure that brings together the characteristics of both partnerships and corporations. Limited liability companies have been around since the 70s, but they have only gained popularity recently. 

Unlike an S-corporation, which has a limit of 100 shareholders, a limited liability company has no such restriction. When registering a limited liability company, you must submit the articles of association with the Secretary of State in the state in which the company intends to do business. In some states, an operating agreement is an additional requirement.  

On the positive side, a limited liability company comes with fewer paperwork requirements when setting up the business than a corporation. The limited liability company provides personal liability protection to business owners, which means personal assets won’t be at risk if your company faces bankruptcy or lawsuits. 

On the downside, a limited liability company costs a fair amount to set up. Also, it may need to hire a technical accountant and an attorney to ensure that it complies with tax and regulatory requirements.

When filing taxes, the profits and losses of the business are passed on to the owners without facing corporate taxes. However, a limited liability company member is considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security.

The bottom line

This article covers the basics of four business structures as well as their advantages and disadvantages. It gives you a good grasp to choose which business structure you’ll go for when you start your “venture” journey.

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