In addition to the liability protections they offer, limited liability companies (LLCs) are popular among small business owners for their federal income tax benefits. LLCs are recognized as pass-through entities that allow businesses to avoid double taxation, simplify tax filing, and provide profit and loss options that may not be available using other business structures.
What is a pass-through entity?
A business and an individual who owns the business are taxable entities. Individuals pay income taxes on their personal income, and companies pay corporate taxes on their revenues. By choosing to set up their business as a pass-through entity, business owners are not subject to corporate taxes.
A pass-through entity is a business structure in which the income generated by the business is passed directly to the individual owners or investors and not taxed at the corporate level.
Each individual reports their income from the business on their personal tax returns and pays their taxes based on their individual income tax rates.
For example, individual LLC owners report their income and business expenses using Form 1040 Schedule C, and multiple-owner LLCs receive a Schedule K-1 from the LLC and report their income on the appropriate forms, such as Schedule E and Form 1065. These forms are submitted along with Form 1040.
Common types of pass-through entities include:
- S corporations: These corporations elect to be taxed under Subchapter S of the Internal Revenue Code. This gives the corporation the option to be taxed as a pass-through entity.
- Partnerships: Whether general partnerships, limited partnerships (LPs), or limited liability partnerships (LLPs), profits and losses are divided among the partners following the partnership agreement.
- Limited liability companies: Owners of LLCs can choose their tax classification. The default is for single-owner LLCs to be taxed as sole proprietorships and multi-member LLCs to be taxed as partnerships.
- Sole proprietorships: The single owner of a sole proprietorship is legally the owner and the business, with no distinction between these roles.
LLCs are business structures, and the owners may choose to have their business taxed as sole proprietorships, partnerships, or S corporations.
Potential Advantages of Pass-Through Taxation
The biggest potential advantage of operating as a pass-through entity for taxation is that the business profits are not subject to double taxation. Business profits are taxed at the individual level and not at the corporate level.
Since business profits are taxed at the individual level, owners can benefit from simplified tax reporting. Small business owners can benefit from lower administrative and accounting costs.
Owners of a pass-through entity may also qualify for deductions such as the Qualified Business Income (QBI) deduction, under which they can deduct up to 20% of their business income. This deduction was introduced by the Tax Cuts and Jobs Act (TCJA) in 2018. It applies to pass-through entities that meet income threshold and other requirements.
Owners of pass-through entities can deduct business losses, which can potentially offset income and reduce tax liability.
Potential Drawbacks of Pass-Through Taxation
Owners, depending on their business structure, may be subject to self-employment taxes. Paying the employer and employee side of the taxes increases the owner’s tax liability.
S corporations offer potential savings on self-employment taxes. Business owners must be paid a reasonable salary and pay taxes on this salary, but income generated above this salary is not subject to self-employment taxes.
Some states impose additional taxes or fees on pass-through entities, so it is essential to consider state-level tax obligations when weighing the risks and benefits of each business structure.
Pass-Through Entity vs. C Corporation
Unlike a pass-through entity, a C corporation must pay corporate income taxes and pay taxes again when business earnings are distributed to the shareholders. Avoiding this double taxation is why many business owners choose a pass-through business structure.
If you are starting a small business or looking for ways to reduce your taxes, talk with your Frame Wealth financial advisor to learn more about the potential benefits you can expect based on the structure you choose for your business.
Whether you need assistance with retirement planning, investment management, tax strategies, or comprehensive financial planning, I am here to help. Our commitment is to assist you in making well-informed choices in today’s dynamic economic environment.
Give us a call today at 866-395-1786 or contact us online to schedule a meeting and discuss your unique financial needs. Let us be your trusted partner on the path to financial success.
