Pass-through Entities

by mark.shead on December 14, 2006

The government has created some special types of corporate entities for small and medium sized businesses called pass-through entities. These types of organizations pass their profits on to the owners every year, so they don’t have to pay any income tax as a corporation.

The main reason this can work out to your advantage is because the money that is passed through to the owners isn’t subject self-employment taxes because it is treated as passive income. This means you don’t have to pay Medicare and Social Security taxes on the profits from the company.

If you run a business as a sole proprietor under your own name or as a DBA, you’ll have to pay self-employment taxes on the money you make because it all shows up as your salary. By using a pass-through entity you can pay yourself a reasonable salary (which you’ll pay all the regular taxes on) and then take the rest of the profit out as investment income (which you won’t pay self-employment taxes on).

The two types of pass through corporations are Limited Liability Corporations and S Corporations. An S Corporation is similar to a regular corporation, but it is structured for smaller businesses. There are specific rules about who can own and S Corporation and the number of owners allowed. However, it can work quite well for a small to midsized business. Another advantage of an S Corporation is that it can easily be converted into a regular C Corporation.

LLCs are a newer type of corporate entity and they aren’t available in every state. Usually LLCs require less record keeping and fewer corporate formalities than a corporation. In many states the cost to file for an LLC is slightly higher than that of a corporation. LLCs allow you a bit more flexibility in how voting rights and ownership is assigned.

Pass through entities aren’t always the best choice. There are some restrictions placed on these types of organizations especially in the area of fringe benefits. As always it is best to talk with an experienced tax advisor in order to make the best choice.

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