Passthrough Entities

Lesson

In this lesson, we will discuss passthrough entities, which are businesses that do not pay income tax at the corporate level. Instead, the income, deductions, and credits flow through to the individual owners, who report this information on their personal tax returns. This structure can provide tax advantages for specific businesses and investors.

Practice Question #1

Which of the following is NOT a type of passthrough entity?

A) S Corporation

B) Limited Liability Company (LLC)

C) C Corporation

D) Partnership

Select an option above to see an explanation here.

A) S Corporations are a type of pass-through entity. B) LLCs are a type of pass-through entity. C) C Corporations are not passthrough entities; they are taxed separately from their owners. D) Partnerships are a type of pass-through entity.

Terms

Passthrough entity:: A business that does not pay income tax at the corporate level but passes its income, deductions, and credits through to its owners.
S Corporation:: A type of corporation that meets specific Internal Revenue Service (IRS) criteria and elects to be treated as a passthrough entity for tax purposes.
Limited Liability Company (LLC):: A business structure that combines a corporation's limited liability protection with a partnership's tax treatment.
Partnership:: A business owned by two or more individuals who share in the profits and losses.
Sole proprietorship:: A business owned and operated by one individual, with no legal distinction between the owner and the business.
Schedule K-1:: A tax form used by partnerships, S Corporations, and LLCs to report each owner's share of the business's income, deductions, and credits.
Tax basis:: The original value of an asset for tax purposes, usually the purchase price, adjusted for factors such as depreciation.
Qualified Business Income (QBI) deduction:: A tax deduction for eligible passthrough entities that allows owners to deduct up to 20% of their qualified business income.
Self-employment tax:: A tax paid by self-employed individuals, covering Social Security and Medicare taxes that an employer typically withholds.
Double taxation:: The taxation of the same income twice, such as when a corporation pays taxes on its profits and shareholders also pay taxes on dividends received from those profits.

Practice Question #2

What tax form is used by passthrough entities to report each owner's share of the business's income, deductions, and credits?

A) Schedule C

B) Schedule K-1

C) Form 1120S

D) Form 1065

Select an option above to see an explanation here.

A) sole proprietors use Schedule C to report their business income and expenses. B) passthrough entities use Schedule K-1 to report each owner's share of the business's income, deductions, and credits. C) Form 1120S is the tax return for S Corporations. D) Form 1065 is the tax return for partnerships.

Do Not Confuse With

C Corporation:: A type of corporation that is taxed separately from its owners, potentially leading to double taxation.

Practice Question #3

Which of the following is a potential tax advantage of operating as a passthrough entity?

A) Avoiding double taxation

B) Lower capital gains tax rates

C) Tax-free dividends

D) Lower self-employment taxes

Select an option above to see an explanation here.

A) Passthrough entities can help business owners avoid double taxation by not paying income tax at the corporate level. B) Lower capital gains tax rates are not specific to passthrough entities. C) Tax-free dividends are not specific to passthrough entities. D) Lower self-employment taxes are not specific to passthrough entities; some passthrough entity owners may be subject to self-employment taxes.

Historical Example

In the 1980s, the United States saw a significant increase in businesses choosing to operate as passthrough entities, such as S Corporations and LLCs. This trend was partly driven by changes to the tax code that made these structures more attractive to business owners seeking to avoid double taxation and reduce their overall tax burden.

Practice Question #4

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Example Series 65 Example Practice Question

Real-World Example

Jane and John decide to start a small consulting business together. They choose to form an LLC, which allows them to enjoy the limited liability protection of a corporation while also benefiting from the tax advantages of a pass-through entity. Each year, they receive a Schedule K-1 that reports their share of the business's income, deductions, and credits, which they include on their personal tax returns.

Practice Question #5

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Example Series 65 Example Practice Question

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