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? 

We walk you through the pass-through structure and taxation, 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.

5-minute explanation on pass through entities.

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 4 different types of pass-through entities to help you better understand why you should or shouldn’t use each one.

1. Sole proprietorships

Sole proprietorships are the most popular type of pass-through entity, and 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. 

2. 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.

3. 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 pay 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.

4. 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).

Pros and cons of pass-through entities

Let’s take a look at the benefits and drawbacks of pass-through entities before deciding whether to use a pass-through entity for your business.

Pros 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.

Cons 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).

You might also be interested in: 

  • Special Corporate Tax Deductions That You Need to Know
  • All You Need to Do for Stress-Free Corporate Tax Preparation
  • A Comparison Between Corporate and Individual Tax Formulas in the US

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