What Are the Tax Benefits of Pass-Through Entities?

 Posted on June 20, 2024 in Small Business Taxes

For business owners, choosing the right business structure is a critical decision that can have significant tax implications. Many businesses are structured as pass-through entities, which can offer unique tax advantages. An experienced attorney can help business owners understand these benefits and make informed decisions about business structure while also ensuring that the proper steps are taken to meet legal requirements and address tax-related issues.

How Taxes Are Handled for Pass-Through Entities

Pass-through entities are business structures in which taxes apply to the income earned by owners or investors, bypassing corporate income taxes. Business profits and losses will be reported on the owners' personal tax returns. Tax issues that may affect different pass-through entities include:

• Sole Proprietorships: This is the simplest form of business ownership, with one individual owning and operating a business. The owner will report business income and expenses on Schedule C of their personal Form 1040. They will also be responsible for paying self-employment taxes, which cover Social Security and Medicare contributions.

• Partnerships: Businesses with multiple owners may be structured as general partnerships (GPs) or limited partnerships (LPs). The partnership itself will file an informational return (Form 1065), and each partner will receive a Schedule K-1 detailing their share of the profits and losses, which they will report on their personal tax returns. General partners will be required to pay self-employment taxes on their share of the partnership income.

• Limited Liability Companies (LLCs): These flexible business structures offer liability protection for owners (members) while allowing for pass-through taxation. An LLC with a single member is a disregarded entity that is taxed similarly to a sole proprietorship, while multi-member LLCs are treated as partnerships. LLCs can elect to be taxed as S-corporations or C-corporations. Members of LLCs taxed as partnerships will be required to pay self-employment taxes on their share of the income.

• S-corporations: These corporations may elect to pass profits and losses through to shareholders. An S-corp will file an informational return (Form 1120S), and shareholders will receive a Schedule K-1, reporting their share of the income. S-Corp shareholders who actively participate in the business must be paid a reasonable salary, and these wages will be subject to payroll taxes. The remaining income passed through to shareholders is not subject to self-employment taxes.

Advantages of Pass-Through Entities

Pass-through entities offer several tax benefits, including:

• Avoidance of double taxation: Unlike C-Corporations, which are subject to corporate taxes as well as taxes on dividends paid to shareholders, pass-through entities are only taxed once.

• Business income deductions: The Tax Cuts and Jobs Act of 2017 introduced a 20 percent deduction for qualified business income (QBI) from pass-through entities. This deduction can significantly reduce taxable income for eligible business owners, providing substantial tax savings.

• Simplified tax filing: Pass-through entities generally have simpler tax filing requirements compared to C-corporations. This can reduce administrative burdens and lower accounting costs for owners of small businesses.

• Flexibility in loss deductions: Owners of pass-through entities can deduct business losses, potentially offsetting other sources of income and reducing overall tax liability.

• Easier profit distribution: Pass-through entities offer flexibility in distributing profits among owners. For example, partnerships and LLCs can allocate income and losses in ways that do not necessarily correspond to ownership percentages, allowing for tailored profit-sharing arrangements.

Contact Our San Jose Business Formation and Tax Attorney

If you are considering forming a pass-through entity, or if you have questions about the tax implications of your business’s structure, the San Jose, CA business tax lawyer at John D. Teter Law Offices is here to assist you. We can guide you through the complexities of business formation and ensure that your business is set up to maximize your tax benefits. Call our office at 408-866-1810 to schedule a consultation.