Small business owners have several options for organizing their business for tax purposes. In addition, in the eyes of the IRS, you are a “flow-through entity” if you sell items on eBay or Etsy, drive for Uber, or offer your services as a writer or programmer. Frankly, so much individual tax is paid by these small businesses. It is important for all taxpayers to have an understanding of the tax code’s logic regarding pass-through entities.

What is a pass-through entity?

Pass-through entities do not pay taxes with a separate business tax return. Instead, the business’s taxable income is on the owner’s individual tax return. A sole proprietor reports this on their Schedule C, while other entities, such as partnerships and S corporations, report owners’ respective shares of profits via a K-1 tax form.

Generally, business owners prefer pass-through entities because:

1. The business income is taxed once instead of twice, as in the case of C corporations
2. The business format provides owners a level of legal protection that is not available by doing business as a sole proprietor

What you should know

• Individual tax rates. Changes in individual tax rates affect the amount of tax paid by all small businesses organized as pass-through entities.
• 20% QBI deduction. A 20% qualified business income deduction is available for pass-through entities and sole proprietorships. There are limitations and other complexities involved, but the bottom line is that many small business owners will see a tax break due to this deduction.
• Owing the tax and having money to pay it can be a problem. Small pass-through business owners must pay income tax on their share of business profits. However, it is not a requirement of the business entity to distribute cash from the company to help pay the tax. So pass-through owners could face a tax bill without the money to pay it.
• Concerns for minority shareholders. Minority shareholders may not only be unable to receive distributions to pay taxes due, but they are often precluded from selling their shares, and they do not have sufficient ownership to require a distribution of funds through shareholder voting.
• Popular business entity type. According to IRS statistics, S corporations are a popular business entity type, with 5.1 million in 2021. That is roughly three times the number of C corporations. LLCs are quickly becoming the new entity of choice, with growth from 120,000 entities in 1995 to over 21.6 million entities in 2025.
• LLC is not a tax entity choice. If you are in an LLC, you can choose how you wish to be taxed. You can choose a partnership or a corporation. So review your choices and make the decision that best fits your needs.
• Understand how FICA and other tax rules apply to your business. When making a pass-through election or change for your business, understand how Social Security, Medicare, and benefits are taxed and made available to your business. Understanding this can really impact how your business is taxed. For instance,
  • Partners in a partnership cannot make pre-tax contributions to a Health Savings Account
  • Company-provided health care is treated as a guaranteed payment to partners, since they are not considered employees
  • FICA is not paid on S-corporation earnings as long as owners take a reasonable salary

Understanding pass-through entities

With 95% of small businesses taxed on personal tax returns, it is important to understand that raising individual tax rates effectively increases taxes for most businesses in the United States. And given the diverse tax rules around these different pass-through entities, it makes sense to periodically review your business to ensure your entity choice still makes sense. As always, feel free to contact RRBB Advisors if you have any questions.