3 Ways You're Affected By The Pass-Through Entity You Choose

Are you considering forming a pass-through entity for business purposes? Modern entrepreneurs have many options today when it comes to choosing a business entity, and more and more owners are opting for a pass-through entity. But before you jump into such formation, here are three key elements to understand.

Income Recognition

Generally, pass-through entities — such as S corporations and partnerships — must pass through most or all of their income to the owner for income tax reporting. You would report income and pay taxes on this money whether or not you need it, and sometimes whether or not you actually withdraw it. If you don't plan on taking all your available income from a new business, you may end up declaring more than you need without the ability to defer it to another tax year. 

Along with the normal income taxes on that extra income, you may also be subject to self-employment tax on it. This hefty tax to pay for Social Security and Medicare contributions is partially paid by the company for employees of a C corporation, not due from limited partners, and paid in full by general partners. Clearly, the type of structure and how you fit into it are a big part of your tax bill. 

New Deductions

One reason that many entrepreneurs are considering pass-through entities these days are the ability to take advantage of new deductions on their income taxes. Tax reform laws of 2018 added one valuable deduction, known as Qualified Business Income deduction. Using this, a pass-through owner could potentially deduct up to 20% of their business income from their taxable income. This adds up quickly.

In addition, a shareholder who performs work for the business may be able to deduct business expenses that employees of C corporations cannot currently deduct.

Liability Protection

When you choose to create a pass-through entity, you get many of the same liability protections as C corporations. You are, in general, considered a separate entity from the business and are not obligated to pay its debts personally. If you form a sole proprietorship, you generally get no liability protection. 

But that protection may also be limited depending on the way you set up your ownership. General partners, for instance, generally have much less financial protection (from debts and obligations of the business) in a partnership than a limited partner. So, if liability protection is valuable to you, you'll want to ensure you get the maximum possible amount of protection. 

Before making any decision about whether to form a pass-through entity or choose a more traditional business structure, consult with an experienced accountant and tax preparer. By doing so, you could save yourself hundreds or thousands of dollars every year — money that you can then put into improving your life or your business in the long run. 

To learn more about business tax preparation, contact a company in your area like Hough & Co CPA. 

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