An Introduction to the Pass Through Concept: To understand the differences between business structures, it’s important to consider how a particular structure impacts your taxes. Some businesses are pass through entities, and others are not.
These entities pass through profits and losses directly to a single owner. Assume, for example, that Bob owns a gift shop as a sole proprietor. The gift shop profits pass through to Schedule C of Bob’s personal tax return (Form 1040).
The business profit on Schedule C is added to other income on Bob’s personal return, and that total goes into the tax calculation. Let’s say that Bob files a joint tax return with his wife Sue. Bob’s gift shop business generates net income of $50,000 for the year, and Sue receives a W-2 form with gross wages of $60,000 from her job. Bob and Sue also earn $2,000 in interest and dividend income. All of these amounts are included as income on Bob and Sue’s joint tax return.
S Corporations (S corps), Limited Liability Companies (LLCs) and Partnerships
These businesses are also pass through entities. The terms differ slightly between each type, but all three entities pass through profit and losses directly to the owners. LLC owners are referred to as members, S corp owners are described as shareholders, and partners have ownership rights in a partnership. Ultimately, the profits generated by all of these businesses flow through to the owners.
C Corporations (C Corps)
When most people think of a “corporation”, they’re referring to a C corporation (C corp). C corps are not pass through entities. Instead of a sole proprietorship, assume that Bob owns 80% of a chain of gift shops that operates as Openmeadow Gifts, a C corporation. Openmeadow files a tax return and pays taxes on the profits generated by the corporation.
Let’s assume that Openmeadow earned $100,000 last year and paid $20,000 in corporate income taxes. Keep in mind that the tax rate schedule for corporations is different from the tax tables used for individual income taxes. Say that Bob receives $40,000 in dividends on Openmeadow’s profits. The $40,000 is posted as income to his individual tax return, and Bob will pay ordinary income tax on the dividends.
It’s important to understand that C corp earnings are taxed twice, while the profits on sole proprietors, S corporations and partnerships are only taxed once.