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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Qualified Business Income Deduction And Who Is Eligible?

The qualified business income deduction (QBI) is a tax break that allows self-employed and small-company owners to deduct up to 20% of their qualified business income from their taxable income.

What is a qualified business income deduction?

At the end of 2017, the Tax Cuts and Jobs Act formed a new business deduction known as the qualified business income deduction

What is the qualified business income deduction for?

This deduction is intended to lower the tax rate for pass-through entities and sole proprietorships

One of the Tax Cuts and Jobs Act’s main goals was to lower the corporate tax rate for C corporations, which was reduced from a top rate of 35% to a flat rate of 21%. However, the bulk of American businesses that are not constituted as C corporations do not benefit from a drop in the corporate tax rate. 

As a result, the qualified business income deduction was introduced to help pass-through enterprises and sole proprietorships decrease their effective tax rate.

Who is eligible for the deduction?

Business income 

To begin, you must have a source of business income. For this deduction, most income from a pass-through company, such as a partnership or an S corporation, is deductible, as is income from a sole proprietorship, which you report on Schedule C of your Form 1040.

Taxable income 

Second, you can determine what to do next by considering your taxable income, calculated prior to applying this deduction. You can get the deduction of 20% the lesser of your business income or 20% of your taxable income over your net capital gain if your taxable income is below a particular threshold amount, which is a defined dollar figure adjusted annually for inflation.

If your taxable income is above the threshold amount, then you can try taking two additional criteria.

The first criterion is based on your job or the source of your income. If your business income comes from a “specified service business,” you can’t use the deduction. 

What is a “specific service business”? It can be defined as a business that deals with health, legal, accounting, actuarial science, the performing arts, consultancy, athletics, financial services, or brokerage services.

For instance, if you are a doctor, a lawyer, or an accountant, and your income is over the threshold amount, you will not be eligible for this deduction. However, if your income is below the threshold, this restriction will not apply to you, and you will be able to claim the deduction. You may be entitled to a partial deduction if your income falls between the threshold and the phase-out amount.

The second criterion for taxpayers having taxable income above the threshold level is the qualifying wages and qualifying investment criterion.

Because the purpose of the deduction was to encourage business growth and job creation, a taxpayer’s ability to claim the credit is limited by one of two additional criteria. The taxpayer can choose to use either of these two criteria and will take whichever one results in a larger deduction for them.

The first criterion is that the limitation of the deduction is set to 50 percent of W-2 wages paid to the business’ employees. 

However, if the business does not have employees, the owner can choose to use the alternative test which has the deduction’s limitation of 25 percent of the W-2 wages paid to employees, plus 2.5 percent of the business assest’ cost. 

To sum up, the qualified business deduction is determined at 20 percent times the lesser of the two criteria – qualified business income or taxable income. 

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LLC vs. LLP vs. Sole Proprietorship: Choosing a Business Structure and Why It Matters

Choosing the right business structure has a huge impact on the financial health of your business. Here’s a breakdown of the big three you should know about.

Choosing the right business structure has a huge impact on the financial health of your business.

The wrong structure could leave you vulnerable to lawsuits or leave you with a large tax debt, while the right structure will protect your assets and ensure steady growth.

For small business owners, the choice between an LLC, LLP, or sole proprietorship can be confusing at best. Here’s a breakdown of the three major types of small business structures, and the pros and cons of each.

Sole Proprietorship
What it is: A sole proprietorship means that you are an individual, independent contractor who is in business for and with yourself; the term “solopreneur” perfectly embodies this business structure. Sole proprietorships are the most popular business structure in the United States.

Pros: A sole proprietorship is easy to form and cost effective. This business structure allows you to hit the ground running – all you need to start your business is, well, some business! When your first customer makes that first purchase, a sole proprietorship is born. As long as you have any required certifications and licenses for your particular industry, you don’t even have to make any special tax considerations for your business until it’s time to file.

Cons: As a sole proprietorship, all of the costs and risks associated with your business are yours, and yours alone. Since you and your business are one entity, you are personally liable for any and all debts or legal action brought against your company, and your personal assets, such as your car, house, and bank accounts, are at risk.

LLC
What it is: A Limited Liability Corporation (sometimes called a Limited Liability Company) is a business structure that can be formed by an individual or multiple people. Unlike a sole proprietorship, an LLC differentiates between the individual and the business, offering personal protection from business liabilities.

Pros: In most states, LLCs can be formed by any professional or group looking to do business together. This means you can work with other people and pool your resources to start a business. Under an LLC, your personal assets, such as your savings and your house, are usually protected if the company is sued. It may also be easier for startups to raise capital as an LLC.

Cons: LLCs are expensive and time-consuming to start compared to sole proprietorships, and require a lot more paperwork up front. Members of an LLC may not be held personally liable for company debts, but they can be held liable for mistakes made by another member of the LLC. For instance, if one business owner defaults on a loan made to the LLC, all parties can be held responsible. Also, if an LLC is formed as an S or C corporation, it can be taxed twice on the same profits by the IRS.

LLP
What it is: A Limited Liability Partnership is similar to an LLC, but offers slightly different tax implications. In many states, LLPs can only be formed by licensed individuals like lawyers, architects, and doctors.

Pros: Unlike some LLCs, which may be double-taxed by the IRS, LLPs are treated as partnerships and offer ‘pass through’ taxation. This means that partners in the LLP are only taxed once on their personal income taxes. Another big advantage of forming an LLP is that partners are protected from one another, in that they’re not liable for the other’s mistakes. If one partner behaves badly and the LLP gets sued, the other partner can’t be held personally responsible for their actions.

Cons: This business entity is not available to everyone, and is restricted to licensed professionals only in many states.

The business structure you choose should take into consideration your industry, budget, assets, and business goals. Consider consulting a tax professional to see which structure is the best bet for your business.

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