A pass-through entity is a special business structure that is used to reduce the effects of double taxation. Pass-through entities don't pay income taxes at the corporate level. Instead, corporate income is allocated among the owners, and income taxes are only levied at the individual owners' level.
How it works (Example):
Company XYZ is a pass-through entity. It files a tax return that looks like this:
Earnings Before Interest & Taxes (EBIT) 500,000
Interest Paid (100,000)
Earnings Before Taxes (EBT) 400,000
Net Income Available to Owners 400,000
XYZ has two owners, Jane and Bill, who each own 50% of the company. XYZ sends both Jane and Bill an IRS Schedule K-1 that reports their portions of XYZ's pass-through income. Jane and Bill each file their own tax return with $200,000 reported as income. It is important to note that Company XYZ allocates the income to Jane and Bill regardless of whether the $400,000 in Net Income is actually distributed.
For example, assume that Jane's tax burden ends up being 20% of $200,000 for tax year 2009. She owes the IRS $40,000, but XYZ did not make a distribution in 2009, and it may not make a distribution in 2010, either. Jane is responsible for taxes owed on income that she did not actually receive.
Losses are also passed-through to owners, but the total deductible amount available is limited to the original investment amount.
Examples of pass-through entities include sole proprietorships, S corporations, master limited partnerships (MLP), limited liability partnerships (LLP) and limited liability companies (LLC).
Why it Matters:
This special tax status eliminates the double taxation issues that affect most corporations and their shareholders since only the owners are taxed.
While eliminating double taxation may be advantageous, pass-through entities may not be the best way to organize your business. There are often restrictions placed on some types of fringe benefits, and there can be rules about how many owners are allowed. It is always best to talk to an experienced tax advisor before deciding how to organize your business.
One of the best income-producing investments for individuals is the master limited partnership.