Definition of Pass Through Entity
Unlike the other corporate entities, pass through entities are the entities which are not considered as an individual entity for separate tax liability for the income it generates instead of that all the income or profit derived by the entity is transferred to the owner’s account and the same is taxable in the hand of the owner.
Explanation
In the case of a normal corporate entity, the corporate tax is charged on the income derived by the entity and after the appropriation of the same, the remaining amounts are transferred to the shareholders of the company. In the case of the pass through the company which is also known as flow through entity, the revenues are not taxed in the hand of the entity instead the same is taxed directly in the hand of owners or promoters. This way the entity avoids the dividend tax paid during the dividend announced to be paid to the shareholders or investors. This helps in removing the double taxation or could be said as a cascading effect caused due to the dividend tax on the income on which later the income tax is also charged.
Examples of Pass Through Entity
Let say person A has a small business or is self-employed. Let say his income from the business is taxed at the rate of 30 percent as the corporate tax rate. But when the personal income of the business owner was evaluated it was found that it will fall into the bracket of 20 % even after accumulating the income of the business. Seeing this opportunity the A person could incorporate a pass through entity and could benefit from the same.
Types of Pass Through Entity
In major, the pass through entity could be divided into three types of business which are namely-Sole Proprietorship, Partnership & S Corporation. These could be defined as:
- Sole Proprietorship: A sole proprietor is a person who has to own an unincorporated business by himself and all the income & expenses arising from the business is charged on the personal tax return of the person. If the person choses to treat the business entity as a separate corporate entity then in that case such will not be treated as a sole proprietorship business.
- Partnership: As in the case of a sole proprietorship, the business is solely owned by a single person; in the case of a partnership the unincorporated business is owned by a group of people and the income & expenses are treated in the hands of the individual and not in the separate business entity.
- S Corporation: This type of corporation is similar to the simple corporate entity where only upto 100 shareholders could exist at the same time. Among the shareholders, there should be no non-residential person as well and a similar type of stock is issued to all of the shareholders of the entity.
How to Form Pass Through Entity?
Entrepreneurs have to analyze their personal income tax rate range before incorporating a pass through entity. To form a pass through entity, the person first need to identify the business in which he wants to engage & take a decision regarding opt for a sole proprietorship or Limited Liability Partnership. In the case of LLP, the same should be registered with the registrar of the state where the person is going to engage his business. In some of the cases, the sole proprietors also need to acquire a license from the states or cities to operate and for the same, they have to register a name and apply for an employee identification number and after the registrations and the permit, the person can start engaging in the business.
Pass Through Entity Tax
In the case of pass through entity, the tax on the income earned is does not directly charged in the hands of the entity but is distributed to the shareholders & owners of the entity, and the income is charged in the personal income tax returns of the individuals. In this way, the entity does not have to pay taxes on the dividend distributed to the shareholders, and hence the double taxation on the same income is avoided. Hence the payment of the taxation on the income of the pass through entity lies completely in the hands of individual shareholders & the owners and not in the hands of the corporate entity.
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Advantages of Pass Through Entity
The small vendors and the small business owners have lots to take advantage from the concept of Pass through Entity and some of the advantages are as follows:
- The main attraction and advantage towards the opportunity of pass through entity are that it enables the business owners to avoid the double taxation effect of the income generated from the business. Not only the avoidance of the double tax, but the pass through entity also enables the owners to avoid the multilayer tax to be paid in the case of a corporation as the tax is charged as individual tax rates.
- Depending upon the personal income of the business owners, the rate of tax could be low as it is the same as the tax rate charged to an individual which is mostly higher than the corporate tax.
- Through pass through entity, the partners are limited but the person could build a huge corporation as much as he wants with thousands of employees and there is no restriction.
Disadvantages of Pass Through Entity
There are some disadvantages as well for operating with a pass though entity and some of them are as follows:
- The number of partners could be limited and in most of the cases the tax brackets of the individual hit up the top bracket and the maximum tax are charged from them. In these cases, the marginal tax can charge a high amount of tax.
- Although whether the company has created successful profit or not but most of the time the income generated through the business is being taxed in the hands of the owner or shareholder of the entity.
Conclusion
The pass through entity or so to say the flow through entity is mostly beneficial for the small business owners in case their person tax bracket hits low and the income generated from the pass through entity is moderate. In this case, the tax charged on the individual amounts low as compare to corporate tax. Forming a pass through entity gives the owner the feeling of owning a corporation without being obligated to the legislations and rules need to be followed for running a corporation.
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This is a guide to Pass Through Entity. Here we discuss the definition and types of pass through entity along with advantages and disadvantages. You may also have a look at the following articles to learn more –
