Some businesses must pay income taxes. Some need not. Some businesses must file annual federal tax returns. Some need not. During tax season, these issues obviously take on added importance. We have recently fielded dozens of related questions and formed several new business entities. Given the volume of interest in these topics, we hope a primer on pass-thru-entities proves useful for our clients.
To start, a business entity (e.g., Corp, LLC, LLP, etc.) is typically formed to provide business owners with the protections of the “corporate veil”. This legal theory means that business owners are shielded from personal liability for acts of the business. Imagine you own a restaurant and a customer suddenly sues for medical bills associated with food poisoning caused by a sloppy restaurant cook. First, check your menu. Second, check your business’s legal papers. If you have properly formed and maintained a business entity, such as an LLC, the corporate veil should protect you from personal liability. The business entity is still on the hook.
The IRS defines a “pass–thru-entity” as a business entity which “passes its income, loss, deductions, or credits to its owners.” Owners must be “partners, shareholders, beneficiaries, or investors.” In simple terms, a pass-thru-entity generally pays zero income tax to the IRS. Instead, company profit is carried forward onto the owners’ tax returns by way of a K-1 statement. For instance, imagine an LLP with two 50/50 owners. If the LLP enjoys a $100,000 profit in a given year, then each of the owners has incurred a $50,000 taxable income increase on their individual taxes. The corporate veil might protect you from food poisoning, but it will not protect you from the IRS.
Partnerships, joint ventures, and limited liability companies with two or more owners/members are considered pass-thruentities by default. Corporations have an election to make. The business can form as a C corporation (meaning that the business itself will pay income taxes) or as a S corporation (meaning that it constitutes a pass-thru-entity). These businesses generally file a tax return setting forth: (i) the amount of tax liability for the business itself (businesses treated as C corporations) or (ii) the amount of tax liability which carries over onto the business owners’ tax returns (businesses treated as a pass-thru-entity). Limited liability companies with only one owner march to the beat of a similar drummer with one key difference. Unless it elects treatment as a C corporation, single member LLCs are generally considered a separate entity for liability purposes but a disregarded entity for tax purposes. In this case, the single member LLC files no business tax return, as LLC business activity is reflected only on the owner’s tax return.
– Chad J. Cochran