A pass-through entity is a company or an LLC, which has a separate tax return with regard to its owners and the owners’ personal income. A pass-through entity is not a separate entity, but merely a partnership, a limited liability corporation (LLC) or a partnership. The owner of such an entity can claim his or her own individual tax return as an individual and deduct expenses of that individual. A pass through entity, however, is taxed like a partnership in its entirety.
Pass through taxation is not unlike partnership taxation: the difference between the amount of income each partner reports, and the amount of taxable income each partner receives, are determined by the law of partnership. A partnership is taxed at its normal corporate tax rate.
The filer’s share of profit and loss of a pass-thru entity (which is also referred to as the passive income of an entity) is not taxable to the individual. However, an entity that is taxed in this manner may be subjected to other kinds of taxes by the government, such as inheritance taxes, estate taxes, and state and local taxes.
Pass-thrus are usually set up as a tax-efficient business structure. For example, in a sole proprietorship, only one shareholder has to pay income tax, while the other shareholders have no tax liability. An LLC, on the other hand, has two or more owners who pay income tax to the government; however, each owner pays tax on a separate basis, and no single owner is liable for paying the combined amount.
Pass through taxation generally results in higher rates of corporate income tax because more profit is generated by the business than is paid out to the owners of the partnership. That excess of profits made by the business is then given to the owners or shareholders of the pass-thru entity, who pass it on to the other owners of the partnership. The difference between the income tax of each owner of the pass-thru entity, plus the amount of their personal income tax liability, and the amount they are entitled to receive is called the passive income or the business’ pass through tax.
Pass-thrus, in general, are better suited for businesses that have multiple owners, since it lowers the number of owners required to qualify for tax deductions and the amount of income subject to tax. and makes the structure less costly for the government.
It is often used in tax-relief situations in conjunction with a S-corporation (see “S-corporation”) to avoid large tax burdens, while increasing the flexibility of a small business. Because of their pass through status, pass throughs are more attractive than a traditional partnership and are preferred by many private investors. An S-corp’s pass-thru status allows it to offer flexible financing options, such as an unsecured loan to finance growth or expansion.
One of the most important reasons for selecting a S-corp is the absence of the need to pay off the interest of any loans the business makes. Unlike partnerships and pass-throughs, there are no requirements that the business repay any loan that it has made during its existence.
In many situations where an S-corp provides tax relief for its owners, the benefit is quite substantial. In cases where an S-corp provides a large tax relief to its owners, the value of the property and the value of the assets that the owner controls is reduced by the amount of tax relief received, making the S-corp more attractive to investors than other types of pass-throughs.
An S-corp is also a more attractive option in situations in which a partnership can provide tax relief to the owners, but at a much lower cost. In many cases where an S-corp provides a large tax benefit to owners, the S-corp is not required to pay out any distributions of the money it receives from assets. A S-corp that provides a large tax relief to owners can even pass through its interest payments on a tax-deferred basis.
The tax relief provided by a pass-through entity is not available if an S-corp does not receive any sales of assets. Although there are some restrictions in the law that limit what type of assets are included in this category, it generally includes both the income and the losses of an S-corp, along with the passive interests of any partner-owner.