Small Businesses Use Pass Through Entity Tax to Lower Tax Bill
Definition of Pass-Through Entities
Pass through entities do not pay Federal Income Tax. Rather they "pass-through" the income (or loss) to their individual owners. These entities include any type of legal entity that have elected to be taxed as an S-Corporation or Partnership. Many small business owner taxpayers have elected to use an S-Corporation as an effective tax strategy.
We've written several articles on the potential benefits of pass through entities for small businesses, but all of those have focused on the Federal taxation. There is a simple strategy at the state level that can lower your tax bill as well.
Overview of Pass-Through Entity Tax
With the advent of the state and local tax (SALT) $10,000 limit on your Federal itemized deductions, several states (34 for tax year 2023) have passed laws allowing for a Pass Through Entity Tax. These laws allow entities to deduct for tax purposes state taxes paid on behalf of the owners of the entity.
Rather than paying your individual state taxes personally, and thereby being subject to the $10,000 SALT limit, the company pays the taxes for you. They are deductible by the entity on their Federal return, you receive a 100% deduction, regardless the amount, which lowers the taxable income reported to the owners. Then the entity reports those taxes as withholding on your individual taxpayer's state income tax return.
Pass-Through Entities Types
Let's quickly discuss the various types of pass-through entities. It is important to remember than when setting up a new entity, you may elect how that entity will be taxes at the federal level by filing form 8832.
Sole Proprietorships
The default election for LLCs with one member for Federal purposes is a sole proprietor. This means that if you don't elect otherwise, when you obtain an Employer Identification Number for your new entity, the IRS will classify you as a sole-proprietor. You will report your business income on Schedule C of Form 1040.
Partnerships
Partnerships file Form 1065, with the income or loss being reported for the individual members/owners on Schedule K-1. The K-1 is reported on your personal income tax return on Form 1040 on Schedule E. Most small businesses will not file as partnerships, except in limited instances. For example, if the owners want to split the income/loss different than their ownership percentages, a partnership might be a beneficial election.
S Corporations
By far the most popular election for small business, S-Corporations file Form 1120S, again with the profit or loss reported to the individual owners on Schedule K-1, which then goes on Schedule E of Form 1040.
There are limitations as to the number and type of owners of an S-Corporation, so not everyone can elect. Additionally, the K-1's must show the income/loss in the same percentages of ownership. For instance, if there are two owners that each own half of the business, then each will receive a K-1 with half of the total business income or loss.
Limited Liability Companies (LLCs)
LLC's are the more popular legal entity. It is important to remember that the entities are formed at the state level and include Corporations, Partnerships, LLC's, and others. How you elect to be taxed at the federal level is your choice. But beware, your election is permanent, and can have tax consequences if you decide to change later.
Federal Income Tax Purposes
S-Corporations generally do not have to pay any income taxes at the Federal level, with a couple of exceptions.
Pass-Through Entity Taxes
Here are the exceptions where the pass through entity actually has to pay taxes:
Excess Net Passive Investment Income
Built-in gains
Investment Credit Recapture
LIFO Accounting Method Recapture
In these cases, S-Corporations would actually have taxes due on their Form 1120S. None of these entity level taxes apply to partnerships.
Individual Income Tax Returns for Owners/Shareholders/Partners
Individuals report all of the information on Form K-1 on their individual returns. It is important to note that there is a lot more information on the K-1 than just the income/loss. These include:
Interest and Dividend Income
Royalties
Capital Gains and Capital Losses
Gains from sale of depreciated property
Contributions
Credits
Tax exempt income
Foreign taxes paid
Election Requirements
This is where things become complicated. The state rules are not uniform. Some states require an annual election, while others require only an initial election that remains until revoked. Additionally, how the states allocate the withholding tax among owners is different by state.
In some cases, an election by entity in one state will not have the same impact on shareholders that live in another state. If your business files in multiple state, or has owners in multiple states, consult with a tax professional to determine the overall impact and benefit.
Distributive Share vs. Refundable Credit in LLCs and S Corps.
Some states calculate the credit for withholding to the individual entity owners based upon either their pro-rata share or distribute share plus any guaranteed payments.
Some states, like California, the credit for the individual is nonrefundable, meaning if you overpay, you will not receive an individual refund. In California's case, the unused credit can be carried forward for five years. Ideally your state allows refundable tax credits.
Additionally, states have different requirements on who qualifies as resident partners. For instance, North Carolina requires that partnerships can only make the pass through entity tax if all of the partners are individuals, estates, or trusts.
State Income Taxes for Entities with Nexus in Multiple States
If your business operates in multiple states, you may have nexus. Nexus simply means that you have enough economic activity to require you to file a tax return in that state. Traditionally this was determined by things like whether you had employees or physical locations in that state. Now, each state has passed laws that set those thresholds. Usually they are based upon the traditional nexus items like whether you have employees working in that state, but add on items like whether you sell a certain amount of goods or services to residents of that state.
This nexus applies to not just income taxes, but any other taxes the state imposes, like sales tax. This hodgepodge of laws has caused quite a problem for businesses operating in multiple states. Many more businesses now have additional state filings. It is important to work with your tax professional for guidance to determine what state tax forms are required for your business.
