Pass-through businesses are the most common entity chosen for family-owned and closely-held businesses. Consequently, the number of pass-through business entities has increased substantially over the last 30 years. On the other hand, the number of traditional corporations has decreased. Now, pass-through businesses make up nearly 94% of all businesses, and they earn more than 64% of total business net income in the United States. Also, pass-through businesses employ more than half of the workforce in the private sector. Considering these statistics, it is easy to see some of the benefits of pass-through businesses.
Types of pass-through entities
The basic types of pass-through businesses include sole proprietorships, partnerships, Limited Liability Companies, and S Corporations. A sole proprietorship is an unincorporated business owned by a single individual. The business reports its income on schedule C of the 1040 tax form. Partnerships are unincorporated businesses with at least two owners, either individuals or other businesses. Limited Liability Companies (LLCs) have limited liability like a traditional C corporation. An S Corporation is a domestic corporation that can only be owned by U.S. Citizens, with nor more than 100 shareholders.
What does “pass-through” mean?
The term “pass-through” means that the business profits are passed directly through the business to the owners and are reported on the owners’ individual income tax returns. In contrast, a traditional C Corporation pays corporate income taxes at the entity level. The owners or shareholders, also pay taxes on the same income when they receive a dividend or sell their stock and realize a capital gain. Another difference between pass-through businesses and traditional corporations is that owners pay the full tax on their business income each year, as the business earns it. Whereas, the owners of a traditional corporation are allowed to defer taxation under certain situations.
Liability for pass-through businesses
Most LLCs are taxed as partnerships, but an LLC can elect to be taxed as a C Corporation. Traditional partnerships are similar to LLCs, except that they must have at least one partner with unlimited liability for the partnership’s actions and unpaid liabilities. With general partnerships, on the other hand, all members have unlimited liability. As such, LLCs have replaced most partnerships as the chosen business entity when creating a pass through entity.
How Do S Corporations Work?
An S Corporation is most often treated like an LLC, for income tax purposes. However, the payroll taxes of an S Corporation are often much less. After payment of a reasonable salary to shareholders, considered employees of the S Corporation, any additional distributions will not be subject to payroll taxes. On the other hand, the ordinary income of a working LLC member or partner is subject to payroll taxes.
If you have questions regarding pass-through businesses, or any other family-owned business planning needs, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.