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May 18, 2023
Pass-Through Taxation: What You Need to Know
Most US businesses have a pass-through taxation structure: they are not subject to corporate tax. Instead, they have their income “pass through” to their owners to be taxed on their individual income tax returns.
Pass-through businesses have simpler filing and a lower tax rate than C corporations because they avoid double taxation. Pass-through business owners must pay self-employment taxes, however, in addition to state and local taxes. C corporations are eligible for some tax breaks that pass-throughs do not qualify for, although pass-through entities may qualify for a special deduction under a tax law that took effect in 2018.
Taxation is not the only factor to consider when selecting a business structure. Not all pass-through businesses enjoy limited liability protection, and unincorporated businesses may face limitations with growth and financing.
Types of Pass-Through Business Entities
According to the Internal Revenue Service (IRS), a pass-through entity is a business that passes its income, loss, deductions, or credits to its owners. It does not typically have an entity-level tax liability.¹ Many entities offer options to enjoy pass-through taxation; however, how an entity accesses this option varies depending upon the type of business.
- A sole proprietorship is the default structure of a business owned by a single taxpayer, such as a freelancer or independent contractor. Sole proprietorships are the most common type of pass-through entity. The owner of a sole proprietorship reports business income on Schedule C of a 1040 tax return.
- A partnership has multiple owners. The owners can be individuals or other businesses. Partnerships make up around 11 percent of all pass-through business entities. They file an entity-level tax return, but each partner’s business income, which is distributed according to the partnership agreement, is reported separately using Form 1065.
- A limited liability company (LLC) has a flexible structure that allows it to be taxed as different pass-through entities, as well as a C corporation. An LLC with one member/owner is taxed as a sole proprietorship by default, while an LLC with more than one member/owner is taxed like a partnership. An LLC can also elect to be taxed as a corporation by filing Form 8832.
- A corporation, sometimes referred to as a C corporation, is subject to double taxation as a default. That is, corporate income is taxed once at the corporate level through the corporate income tax and a second time at the individual level through the individual income tax on capital gains and dividends.² However, C corporations may elect to receive a special pass-through designation as an S corporation.
About the S Corporation Tax Election
An S corporation is a tax election limited to US citizens and businesses with up to 100 shareholders. S corporations file federal income taxes using Form 1120-S. Each shareholder reports their business profits and losses. About 13 percent of pass-through businesses are S corporations. LLCs and corporations may elect to be taxed as pass-through entities by filing Form 2553.
Avoiding double taxation is a major incentive for businesses to organize as pass-through entities and explains why about 95 percent of US businesses are pass-throughs.³ These types of companies employ more than half of all private-sector workers and account for around 40 percent of all private-sector payroll.⁴
High-income taxpayers earn the majority of pass-through business income. About 45 percent of pass-through income is earned by taxpayers who make $500,000 and over. Pass-through status lets these taxpayers avoid double taxation, but their business income could place them in a higher tax bracket.
To take the sting out of pass-through business income taxes, owners may be able to exclude up to 20 percent of qualified business income (QBI) from federal income tax using the Qualified Business Income Deduction. The pass-through deduction was added through the Tax Cuts and Jobs Act (TCJA) of 2017. The law’s details are complex, though—not all businesses qualify for the QBI deduction, and determining eligibility requires a multistep approach.⁵
Disadvantages of Pass-Through Status
Not having to pay taxes twice on business income is a major benefit of pass-through entities, but the tax picture is more complex than double taxation versus single taxation.
- C corporations do not have to pay taxes on retained earnings or profits that are reinvested in the business. Flow-through entities, on the other hand, typically must pay taxes on all earnings, whether they are retained. As a result, flow-through businesses may have more of an incentive to distribute profits as dividends to owners, rather than use them to build the business.
- C corporations can deduct fringe benefits—things like health insurance, paid time off, and commuter benefits—from their taxable income. Flow-through entity owners, however, may not write off fringe benefits.
- C corporations might be able to write off more charitable deductions than pass-through businesses. C corporations can generally make tax-deductible charitable contributions up to 10 percent of their taxable income. Pass-throughs can deduct charitable contributions as well, but only if they itemize their deductions.
- C corporations can issue an unlimited amount of stock, making them much more attractive to investors. Among pass-through entities, only S corporations can issue stock, but only up to 100 shareholders, and only one class of stock.
- Not every type of pass-through entity offers limited liability. Starting a pass-through entity, especially a sole proprietorship or general partnership, is relatively simple. These types of businesses are created by default, without their owners having to file any paperwork with the state. Yet unlike a corporation or LLC, an unincorporated business is not a legal entity separate from the owners. Unincorporated businesses have unlimited liability. In the event of a bankruptcy or lawsuit, creditors can go after the personal assets of the owners.
Which Structure Is Right for Your Business?
Choosing the proper business entity structure involves balancing several factors. Owners are in business to make money. Most want to earn—and keep—as much income as possible. Federal taxes are just one piece of the taxation puzzle. State and local business taxes must also be considered to get a complete picture of a business’s tax rate. In addition, the tax breaks that you qualify for may change as your business grows and becomes more complex.
A simple business structure can make sense early on when you are effectively self-employed, have no employees, and face little exposure to liability. But at some point, it could make sense to transition a sole proprietorship or general partnership into an LLC, elect to have your LLC taxed as a corporation, or change your S corporation to a C corporation. There can be many different reasons to change an existing business structure, including not only tax considerations, but also limited liability protection, raising money from outside investors, succession planning, and hiring employees.
Before selecting a business entity, you should discuss the issues with an attorney. Once we learn more about your business, financials, and goals, we can explain your options from every angle so you can make an informed, confident decision. Contact our office to set up an appointment today: www.calendly.com/macklaw/initial-consultation.
The Nosy Lawyer™
(248) 562-6423
¹ Procedures and Authorities, IRM 8.19.1 (Apr. 19, 2016), https://www.irs.gov/irm/part8/irm_08-019-001.
² Double Taxation, Tax Foundation, https://taxfoundation.org/tax-basics/double-taxation/ (last visited May 17, 2023).
³ Aaron Krupkin and Adam Looney, 9 facts about pass-through businesses, The Brookings Inst. (May 15, 2017), https://www.brookings.edu/research/9-facts-about-pass-through-businesses/#fact5/.
⁴ Kyle Pomerleau, Some Pass-Through Businesses are Significant Employers, Tax Foundation (Feb. 9, 2015), https://taxfoundation.org/some-pass-through-businesses-are-significant-employers/.
⁵ I.R.S. News Release FS-2019-8, Facts About the Qualified Business Income Deduction (Apr. 2019), https://www.irs.gov/newsroom/facts-about-the-qualified-business-income-deduction.
Pamela Denise Mack
Attorney Pamela Denise Mack is the founding and managing member of the firm The Mack Law Group. She founded the firm in 2019, and concentrates her practice in the areas of corporate/commercial transactions and legacy planning, by providing counseling and advice to businesses, business owners, and their families.
Contact us
Bloomfield Hills, Michigan
Phone: (248) 229-0185
info@macklawgrp.com
Small business owners will have one more item on their compliance to-do list when the Corporate Transparency Act (CTA) takes effect next year. The CTA, enacted as part of the Anti-Money Laundering Act of 2020 (AMLA), places new reporting requirements on many business entities in an effort to expose illegal activities, including the use of shell companies to launder money or conceal illicit funds. Around 30 million small businesses will be impacted by the law, which will establish a federal database of information, furnished by “reporting companies,” that will be accessible to certain authorities and organizations. A final rule has been issued stating how the new law will be implemented to help businesses understand whether the law applies to them, how to comply, and which agencies will have access to the information they must report. CTA violations carry civil and criminal penalties, including imprisonment. Why was the CTA passed? The CTA was passed as part of the National Defense Authorization Act for Fiscal Year 2021. It directs the US Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) to gather information from private companies about their owners and controlling persons. Acting Director Himamauli Das said, “FinCEN is taking aggressive aim at those who would exploit anonymous shell corporations, front companies, and other loopholes to launder the proceeds of crimes, such as corruption, drug and arms trafficking, or terrorist financing.” To counter the risks allegedly posed by anonymous shell companies, the CTA mandates the creation of a national registry that contains certain information about business entities that are formed by filing a document with a state’s secretary of state or similar office. What does the CTA require? Effective January 1, 2024, the CTA requires that certain businesses disclose to FinCEN information about the company, its beneficial owners, and in some cases, the company applicant. Reporting companies—defined as any company with twenty or fewer employees that is formed by filing paperwork with the Secretary of State or equivalent official—that are created or registered prior to January 1, 2024, have until January 1, 2025, to file an initial report; reporting companies created or registered after January 1, 2024, will have thirty days after creation or registration to file a report. Small business organizations such as the National Small Business Association (NSBA) and the National Federation of Independent Businesses (NFIB) oppose the CTA, calling it cumbersome, intrusive, overly punitive, and unconstitutional. NSBA states that small businesses are unfairly impacted because they usually do not have compliance teams or staff attorneys. Eighty percent of the small businesses surveyed by NFIB are against the new reporting requirements, which NFIB claims are unclear. NFIB notes that each state has different standards and practices for business entity formation, potentially leading to uncertainty about whether a business must report to FinCEN. For example, some states require sole proprietorships and general partnerships to register with state agencies, while other states do not. Does the CTA require my business to report? The CTA applies to companies that are created by filing a document with a state authority. Typically, this includes corporations and limited liability companies. Depending on the state, it could also include limited partnerships, professional associations, cooperatives, real estate investment trusts, and trusts. In addition, the CTA applies to non-US companies that are registered to operate in the United States. NFIB estimates that, based on these rules, 30 million small businesses will have to report to FinCEN. However, the CTA exempts around two dozen categories of companies, including companies that: are publicly-traded; have more than twenty full-time US employees; filed a previous year’s tax return showing more than $5 million in gross receipts or sales; have an operating presence at a physical US office location; operate in a regulated industry, such as banking, utilities, or insurance, that already imposes similar reporting requirements; or are subsidiaries of exempt organizations. The exemptions, which generally include larger companies that are already subject to regulation, underline the primary purpose of the CTA: to combat money laundering and other illicit activities conducted via small, private, and anonymous shell companies. What information must be provided in the reports? The CTA requires three categories of information to be reported: company, owners, and applicant. Domestic reporting companies created before January 1, 2024 must provide information about the company and its beneficial owners . Beneficial owner is defined in the CTA as an individual who exercises “substantial control” over the reporting company or has an ownership interest of at least 25 percent. Company senior officers, directors, and others who make significant decisions on behalf of the company may meet this statutory definition of “substantial control,” although the broad definition may cause confusion in some instances. Domestic reporting companies created on or after January 1, 2024, must provide information about the company, its beneficial owners, and its company applicants . A company applicant generally is the individual who files the formation document with state authorities for the reporting company. Technically, the information to be filed with FinCEN is called a Beneficial Ownership Information (BOI) Report. The following is what is required in the report for a company, an owner, and an applicant: The reporting company must provide its name and any alternative (DBA) names, the address of its principal place of business, the state of formation, and its taxpayer identification number or FinCEN identifier. Each beneficial owner of a reporting company must furnish their full legal name, date of birth, residential address, and an identification number from a driver’s license, passport, or other state-issued identification (ID), along with a copy of the ID document. A company applicant is required to submit the same information as a beneficial owner. Who has access to FinCEN BOI reports? The CTA authorizes FinCEN to disclose BOI information to five categories of recipients: US federal, state, local, and tribal government agencies Foreign law enforcement agencies, judges, prosecutors, and other authorities Financial institutions Federal regulators US Department of the Treasury FinCEN may only disclose BOI information “under specific circumstances”: there are more stringent requirements for agencies other than those engaged in national security, intelligence, and law enforcement activities. There are also restrictions on how the information may be used and how it must be secured. Some small business owners have expressed concerns about the privacy implications of the CTA. The NSBA has filed a lawsuit challenging the CTA’s constitutionality, in part on privacy grounds over sharing “sensitive information” with the government. Are there penalties for noncompliance with the CTA? Penalties for noncompliance may be steep. Willingly providing false information (including false identifying documents) to FinCEN, or failing to report complete BOI information, can result in: Fines of $500 per day, up to $10,000 Imprisonment for up to two years Civil and criminal liability may be avoided if an individual who submitted an original, erroneous report did not knowingly submit inaccurate information and submits an updated report correcting the inaccurate information within ninety days . Get help with CTA reporting requirements. Understanding how the CTA applies to you, how it will affect your business, and what you must do to comply introduces new burdens that you may have scarce resources to address. Terms like “beneficial owner” and “substantial control” may seem vague and confusing, further complicating compliance efforts. But compliance is critical for business owners who want to avoid possible sanctions. We can help you determine whether the CTA applies to your business and the steps needed to meet its reporting requirements. With the law’s effective date just months away, we encourage you to reach out now to start working on a CTA compliance strategy. Sincerely, The Nosy Lawyer™ The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation. Call us if you have questions about your specific situation. Call us if we can be of assistance to you. Schedule an appointment with an attorney: www.calendly.com/macklawgrp.com - initial consultation link. The Nosy Lawyer™ is a publication of the Mack Law Group, PLC a Bloomfield
When clients seek estate planning advice, they often begin with a request to draft a will or a trust. After a few “nosy lawyer” questions, I discover what they are really seeking is assurance that their affairs are handled in an orderly fashion, so that their family is taking care of when “if” and “when” something happens to them. The “if” is if they are disabled or incapacitated and unable to handle their own affairs, and the “when” is when they die. Estate planning has two essential parts – pre-death death and post death planning. Of course, there are several ways to design plans around these two concepts, but if done correctly, an estate plan should provide an orderly way to address the “if” and “when”. Pre-Death Planning Let’s talk about pre-death planning and how it can avoid stressful situations in the ICU. According to a recent study approximately 1 in 5 patients in the U.S. die in the ICU. The ICU is a place where decisions about care must often be made quickly and decisively. The ability to do so can hinge upon sorting out who can make those decisions, and under what legal authority. This process can come with great deliberation and debate among family members with differing views on a patient’s care, leaving medical professionals stressed in the uncomfortable middle. There is a better way. We recommend our clients prepare with pre-death planning. A Medical Power of Attorney (also called Patient Advocate Designation) importantly allows a patient who is otherwise unable to make medical decisions to designate someone to make those decisions on his/her behalf. Having a properly drafted and executed Medical Durable Power of Attorney can reduce family fights and enable medical professionals to move quickly to take critical medical action. This document is a part of our pre-death planning. It takes the guess work out of who oversees making medical decisions, allows the decisions to be made in accordance with the patient’s wishes, and allows the medical professionals to go about saving lives. Sincerely, The Nosy Lawyer™ The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation. Call us if you have questions about your specific situation. Call us if we can be of assistance to you. Schedule an appointment with an attorney: www.calendly.com/macklawgrp.com - initial consultation link. The Nosy Lawyer™ is a publication of the Mack Law Group, PLC a Bloomfield
Transitioning from being an employee to being self-employed is a goal of many American workers, and a growing number of workers have realized their goal in the wake of pandemic-related economic disruptions. Individuals often cite taking control of their career as a top motivating factor for being self-employed. Self-employment frequently starts as a side hustle that blossoms into a full-time career. Without even knowing it, however, the self-employed may find themselves operating a sole proprietorship. Whether a sole proprietorship is the final destination on a self-employed individual’s entrepreneurial journey or a stop on the way to running a larger business, they should understand the pros and cons of this structure. The Shift to Self-Employment Having a full-time job was once seen as the main path to a successful career. But that perception has changed radically among younger workers, who have learned the hard way that employment does not offer the security it once did. The Great Recession saw roughly one in five employees lose their jobs. It pushed many of them into temporary work, often as contractors; disrupted traditional career paths; and contributed to an overall sense that the economic system is broken. While the economy stabilized in the years after the Great Recession, COVID-19 delivered another blow as millions of businesses laid off staff. The number of self-employed workers rose sharply following pandemic-related shutdowns and layoffs. However, unlike with the Great Recession, the newly self-employed after the pandemic were not just employees who had been laid off from their jobs. Forced to reconsider their work lives during the COVID-19 lockdowns, many workers joined the Great Resignation, willingly leaving their jobs to become self-employed. Self-employment remains above pre-pandemic levels and, if it continues increasing at its current rate, could surpass traditional employment in the coming years. Self-employed Americans comprise roughly 6 percent to 15 percent of the workforce, depending on the source. However, many more Americans want to be self-employed. A 2021 survey conducted by Freshbooks found that 40 percent of traditionally employed Americans were contemplating a shift to self-employment, with half saying it is their top life goal. Among those who are self-employed, 95 percent said they plan to stay that way for the foreseeable future, the study also found. It is not just low-skilled workers, such as rideshare and delivery drivers, that are swelling the self-employed ranks. According to an Upwork survey, highly educated and skilled workers make up a growing share of those providing freelance services. Self-Employment and Sole Proprietorship Workers who are not employed by a specific company may, by default, be operating a sole proprietorship. Unlike a corporation, limited liability company (LLC), or partnership, which require paperwork to be filed with the state and the payment of filing fees, a sole proprietorship typically requires no such formalities. In fact, a contractor, freelancer, or other self-employed individual is automatically considered a sole proprietor by the Internal Revenue Service (IRS) if they operate a business under their own name and are not registered as another business type. Sole proprietors may need to obtain industry-specific licenses and permits to lawfully operate. They can also file an application to conduct business under a fictitious name, called a doing business as (DBA) name. With a DBA, a sole proprietorship entity is not separate from the individual who runs it: legally, they are considered the same. While fictitious name certificates do not provide any significant legal protections, they can help business owners conduct business within a certain geographical space under a specified name. This should not be confused with trademark protections that provide certain levels of exclusivity when it comes to brand identifiers such as names and logos. Benefits of a Sole Proprietorship The simplicity of a sole proprietorship is one of its major advantages. Other than paying taxes, there are typically no required filings or registrations. Startup costs are low, and even tax preparation is relatively simple, since the sole proprietorship is not taxed separately from the business owner. The business’s profits and losses are reported on the business owner’s personal income tax return, which uses the owner’s Social Security number. In addition, sole proprietors can take advantage of tax deductions not available to employees, such as health insurance deductions and business expenses. With the simplicity of a sole proprietorship comes greater control over the business. Although some states permit a married couple to jointly own a sole proprietorship, there are no partners or shareholders to consider. The sole proprietor has the freedom to make every revenue decision—including how much to pay themselves and how much to reinvest in the business. They can guide the business in whatever direction they want. Drawbacks of a Sole Proprietorship Sole proprietors are fully responsible for their taxes, business decisions, and legal contingencies. While this creates freedom, it can also lead to exposure. As the sole owner, manager, and decision maker, the sole proprietor is solely liable for debts and financial losses that the business incurs. Because the business entity is not legally separate from the owner, personal assets are at risk if the business faces a lawsuit, bankruptcy, or financial trouble. The courts could seize a sole proprietor’s home, car, bank accounts, and other belongings to satisfy a liability of the business. Additional drawbacks of a sole proprietorship include the following: It is more difficult to raise capital due to the inability to sell stock, add new owners/members, or secure loans from banks, which tend to see sole proprietors as high risk. Difficulty raising capital can lead to problems growing the business. Sole proprietors generally must pay a self-employment tax of more than 15 percent on all business income. This tax doubles the Social Security and Medicare taxes that employees pay and comes on top of regular income tax. Not having business partners can be seen as a plus, but as the business matures and seeks fresh opportunities and investments, outside partners may be desirable. Sole Proprietors Don’t Have to Go It Alone. We Can Help. Making the jump to full-time self-employment could be the fulfillment of a lifelong goal, but working for yourself is not without challenges. Running a sole proprietorship may not be as simple as it appears on the surface. You might have to choose and register a DBA, register for licenses and permits, purchase a website domain, hire employees and obtain an employee identification number, open a business bank account, buy insurance to mitigate personal liability for business losses, and prove to the IRS that your business is not a “hobby” to reap the potential tax benefits of sole proprietorship. A sole proprietorship may initially be the right choice for consultants, freelancers, independent contractors, and some types of business owners such as franchisees who have minimal startup capital requirements and whose products or services involve a relatively low risk of liability. But at some point, you may decide that you have outgrown your sole proprietorship and want to form a business entity such as a corporation or an LLC. Further, if you plan to grow from the beginning, you may want to consider a different legal structure. During a meeting with our business attorneys, we can discuss the pros and cons of a sole proprietorship, whether it is right for you, how to get started as a small business owner, and ways we can help you meet your business goals. Call or contact us to get started. Sincerely, The Nosy Lawyer™ The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation. Call us if you have questions about your specific situation. Call us if we can be of assistance to you. Schedule an appointment with an attorney: www.calendly.com/macklawgrp.com - initial consultation link. The Nosy Lawyer™ is a publication of the Mack Law Group, PLC a Bloomfield
