A pass-through entity is a business that does not pay income tax of its own. Instead, the business’s income, losses, credits, and deductions “pass-through” to the business owner’s personal tax return; taxes are calculated according to an owner’s individual income tax rate.
Ease of tax filing is among the primary reasons why entrepreneurs choose to operate their businesses on a pass-through basis. Sometimes business owners start their companies as pass-through entities and then incorporate at some point in the future as their organizations grow and evolve.
What kinds of business entities are pass-through entities?
Sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies, and S Corporations are all pass-through entities. Corporations and limited liability companies that elect to be taxed as a C Corporation are not pass-through entities.
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How do you pay yourself if your business is a pass-through entity?
Business owners of sole proprietorships, general partnerships, and LLCs do not receive compensation in the form of wages and salaries because they are not considered employees of their company. They instead get paid through “owner’s draws.” An owner’s draw is when a business owner takes money out of their share of the company’s profits. Typically, they do that by writing themselves a business check or transferring funds from the business to their personal bank account (if their bank will allow it).
Note that LLCs and Corporations that opt for S Corporation election, although also considered pass-through entities, do things a little differently. S Corps must put owners who work in the business on payroll and pay them a reasonable wage or salary for the work they perform.