Starting a business can be confusing, especially when it comes to legal obligations and aspects. One of the important legal aspects in working out what business entity type is best for your business and your tax rates. Below we look at pass-through entity types and tax rates for your business.
A pass-through entity won’t pay business taxes, instead, all business flow is through the owner's tax return. This includes any income, loss, credits, and deductions. The profits of a pass-through entity will get taxed at the owner’s personal tax rate.
Pass-though business entity types include sole proprietorships, partnerships, limited liability companies, and S-corporations. Choosing which entity type is best can be difficult, so here are definitions of each;
Sole Proprietorship – An unincorporated business that is run by one owner or by spouses. This type of pass-through entity uses the tax form ‘Schedule C’.
Partnership – A business that is run by multiple individuals. All individuals share the assets and liabilities of the business. This type of pass-through entity uses tax forms, ‘Form 1065’ and ‘Schedule K-1’.
Limited Liability Company – A business that has fewer compliance requirements than a corporation but still offers limited liability to the owners. This pass-through entity type uses tax forms ‘Form 1065’ and ‘Schedule K-1’.
S-Corporation – A type of corporation that can issue 1 – 100 shares of stock. This type of pass-through entity uses tax forms ‘Form 1120S’ and ‘Schedule K-1’.
The biggest difference between C-corps and pass-through entities is how they pay taxes each year. C-corps pay a flat corporate income tax on business profits, then shareholders also pay personal taxes on business profits when they receive dividends or sell stock. The share dividends can also require shareholders to pay income tax rates or capital gains tax. As the owners of a C-corp pay taxes twice, C-corps have what is known as double taxation.
However, a pass-through entity doesn’t have this issue. This is because they do not have to pay any taxes at the entity level. Many pass-through entities still file information returns with the IRS, but there is no tax payment to submit. This means that owners of pass-through entities are responsible for submitting and paying any federal, state, and local taxes. Tax rules for pass-through entities are the same at both state and local levels in most areas. The only exception is in states that do not levy an income tax.
To decide on whether a pass-through entity is best for your business needs you should consider future growth and your current situation. It can be easier to start as a pass-through entity, but operating as a C-corp can help bring in investors and put funds back into the business. Below are some of the benefits and downfalls of a pass-through business entity.
As you can see, the biggest difference between a pass-through entity and C-corp is the taxation requirements and payments. However, there are a few more considerations to keep in mind. We recommend discussing this with your accountant to choose the best type of business entity for your needs and growth plans.
