What is a pass through entity? This is a common question clients will ask their business attorney or tax attorney. Business owners will have heard the term “pass through entity” but they may not fully understand what the term means and how it will apply to and affect them as an individual taxpayer. The article below has been prepared by a Denver business attorney at The McGuire Law Firm to help explain what a pass through entity is.
Limited liability companies (LLC) and S corporations are two popular entity choices for small to medium sized business owners. The LLC or the S corporation may actually be the preferred entity for the vast majority of small businesses. Both of these entity formats would be considered a pass through entity. A pass through entity generally pays no tax at the entity level because the income (and other items) is “passed through” to the individual shareholders and partners. Thus, the term “pass through” reflects a tax concept or position.
A pass through entity will file an income tax return. S corporations file an 1120S U.S. Corporate Income Tax Return, and a LLC or partnership files a 1065 U.S. Partnership Income Tax Return. However, unlike a C corporation, which pays income tax on net corporate income, no income tax is paid by an LLC or S corporation on the net income. Rather, the income is passed through to the shareholder’s or partner’s who will report the income on their appropriate returns. Generally, an individual will report these items on Schedule E of their 1040 Individual Income Tax Return. Under most circumstances, the shareholder of an S corporation must be an individual and therefore the income and items will be reported on their 1040. However, an LLC may have a member that is an entity. For example, an S corporation may be the member of an LLC and thus the items would be reported to the S Corporation, which would then report the items on the appropriate tax returns and schedules.
The term “double taxation” refers to a C corporation due to the fact the corporation pays tax on income and the individual shareholders pay tax on corporate dividends and distributions. Thus, a pass through entity refers to an entity by which there is a single layer of taxation.
So how are the items of income, gain, deductions etc. reported? This is a great question! How does the IRS know and how do the business owners know what to report? The answer is, Schedule K-1. Schedule K-1 is an information return issued to the shareholder or partner that states the business income (or loss) and other items. Thereafter, the shareholder or partner will report the items on the necessary tax returns and schedules. Thus, the entity has “passed through” the items to other taxpayers who will report the items and pay any necessary tax.
You can speak with a Denver tax attorney or business attorney at The McGuire Law Firm regarding your pass through entity, or other tax and business questions.
Schedule your free consultation with a tax attorney or business attorney by contacting The McGuire Law Firm. The McGuire Law Firm has law offices in Denver and Golden Colorado for your convenience.