What Is A Pass Through Entity?
By: Gregory L. Cartwright
There’s been a lot of talk in the news lately about Pass Through Entities and their proposed tax treatment, and some of the information surrounding these entities – even in the financial press – is at best confusing and at worst inaccurate. To bring some clarity to the topic, I’ll lay out some of the fundamental issues here. As a starting point, a Pass Through Entity is simply a business structure like a corporation, limited liability company (LLC) or partnership that allows a small business to legally reduce the income taxes otherwise owed from its business operations, but what does that mean and how are they created?
What Is Double Taxation and How Can You Avoid It?
Traditionally, when a corporation is taxed on its profits, we say those profits are taxed at the corporate level. Meaning that the corporation, just like an individual, pays taxes on its income as reflected on its tax return. After those taxes are paid, the corporation may wish to give the owners of the corporation – the shareholders – what’s left over by making a distribution to them of those profits. Those shareholders are then taxed on those distributions as well. We call this ‘double taxation’ since the same profits are being taxed twice: once at the corporate level, and again on what’s left over when that’s distributed to the shareholders.
As most businesses are owned by only a few people or even a single person, laws have been passed which allow those small businesses to be taxed only once as if they were an individual, thereby avoiding double taxation. That is what a Pass Through Entity is designed to: avoid double taxation. If properly set up and run, a Pass Through Entity will reduce the total taxes owed from business operations as it ‘passes through’ the profits from the business directly to the owners and therefore avoids the double taxation that corporate profits would otherwise be subjected to. The business is ignored for corporate income tax purposes and instead, all of that profit gets passed through to the owners who then report that income on their personal tax returns.
How Is A Pass Through Entity Created?
When we talk about Pass Through Entities, we’re talking about two significantly different, albeit related, areas of the law: 1. state laws which govern how corporations, LLCs and partnerships are set up and run; and 2. state and federal law governing how such businesses get be taxed. To put it another way the “pass through” part of Pass Through Entity deals with tax law, and the “entity” part deals with state corporate law.
Since LLCs, partnerships, and corporations (with very minor exceptions that don’t apply here) are all created under state law, not federal law, we must first file the appropriate documents with the state government to create the entity. Depending on the type of entity, that document has varying names — corporations require Articles of Incorporation to be filed, LLCs are created using Articles of Organization, and partnerships (depending on the type and where it’s filed) are created with something called a Statement of Partnership or a Certificate of Partnership. In California, those documents get filed with the California Secretary of State. In other states, it might be the Department of Corporations or a similarly named governmental agency. If that seminal document is accepted, your new entity has been created. Of course, there are many other important steps necessary to take such as adopting bylaws or an operating agreement, holding the initial organizational meetings, issuing corporate shares or membership interests if it’s a LLC, adopting shareholder agreements, buy-sell agreements or undertaking other important steps in the formation process. Assuming those have all been taken care of, what else needs to be done to create the Pass Through Entity?
Limited Liability Companies and Partnerships Are Just Born That Way
For some types of entities, nothing further needs to be done to have them treated as a Pass Through Entity. For example, LLCs and partnerships are Pass Through Entities by operation of law. They will usually still have to file a tax return so that tax credits, deductions and other taxes (e.g. sales tax, employment taxes) can all be tracked, and so that the amounts being distributed to the owners can be reported, but their profits are not taxed directly. Instead, those profits are passed through to the members of the LLC or the partners of the partnership who in turn will report that income on their individual tax returns and pay the taxes accordingly.
The “S Corporation” Election
However, if the business has been set up as a corporation, an additional step is needed for it to become a Pass Through Entity. This is done by making an “S Corp election” by filing form 2553 with the IRS. The term “S Corporation” comes from Title 26 of the United States Code, Subchapter S – the portion of the Tax Code which allows for some corporations to be treated as a pass through entity. By comparison, a “C Corporation” is the default status of any corporation not making such an election, and therefore not be treated as a Pass Through Entity. That name comes from, you guessed it, Subchapter C of Title 26 of the United States Code.
If properly and timely filed, the S Corp election will result in the corporation being treated as a Pass Through Entity just as if it were a partnership or LLC for income tax purposes. Of course, the IRS will only grant such an election if all the requirements are met. While not an exhaustive list, key requirements are that it was incorporated in the US, none of the shareholders are nonresident aliens, that there is only one class of corporate stock, that there are no more than 100 shareholders of the corporation. Generally, the state will follow the tax treatment that the IRS does. In other words, the state will treat the LLC, partnership or the S Corp as a Pass Through Entity for state income tax purposes as well without the need to file any additional election or forms other than the state tax returns.
Partnerships, LLCs and S Corporations are all Pass Through Entities that can provide favorable tax treatment to business owners under the right circumstances. However, each have varying requirements and important legal and tax treatment distinctions so it’s important that business owners seek competent legal and tax advice from their lawyers and CPAs early in the process in order to plan accordingly to take full advantage of their options.
© Copyright 2017 Gregory L. Cartwright. All rights reserved.