Pass Through Entity and the K-1
When you hear that you have a Pass Through Entity or you are getting a K-1 – do you know what that means?
Definition of Pass-Through Entities
A pass-through entity is a business structure where the income, deductions, gains, losses, and credits “pass through” to the owners or investors, who report these items on their individual tax returns. These entities do not pay federal income tax at the entity level. Instead, the tax liability is assessed at the owner or shareholder level. Common types of pass-through entities include partnerships, S corporations, and certain limited liability companies (LLCs). LLCs can choose to request a tax election of S-Corp. This is allowable for LLCs that are sole proprietors, partnerships or corporations. The owners must be individuals they cannot be a trust or estate. Partnerships, corporations and resident aliens cannot be owners.
Tax Treatment of Pass-Through Entities
- Income Reporting:
- Pass-through entities file an informational return with the IRS to report income, deductions, and other tax-related items. For example:
- Partnerships file form 1065
- S corporations file form 1120 S
- The entity provides each owner or shareholder with a Schedule K-1, detailing their share of the entity’s income, deductions, and credits. Owners then report these amounts on their individual tax returns.
- Pass-through entities file an informational return with the IRS to report income, deductions, and other tax-related items. For example:
- Qualified Business Income (QBI) Deduction:
- Many pass-through entity owners may qualify for the Section 199A deduction, which allows a deduction of up to 20% of qualified business income (QBI). This deduction is subject to limitations based on taxable income, the type of business, and other factors. This is a federal deduction only.
- Self-Employment Taxes:
- For sole proprietors are subject to self-employment on their Schedule C as a partnership and LLCs taxed as partnerships, partners are generally subject to self-employment taxes on their share of the entity’s income. S corporation shareholders, however, are not subject to self-employment taxes on their share of the entity’s income, but they must pay themselves a reasonable salary subject to payroll taxes. A significant savings on self-employment can be had when choosing to tax as an S-Corp.
- State-Level Taxation
- While pass-through entities avoid federal income tax at the entity level, some states impose entity-level taxes or fees on pass-through entities. For example, North Carolina imposes a minimum Franchise tax on LLCs and S corporation.
Implications for the 2025 Tax Year
- The tax treatment of pass-through entities remains largely consistent under current law. The new tax bill signed by President Trump in July made this deduction permanent. There was some adjustment to the phase in rules allowing more higher earners to qualify for a partial deduction.
- The IRS has announced increased compliance efforts targeting high-income taxpayers and complex pass-through entities, emphasizing the importance of accurate reporting and documentation.
By understanding the tax treatment and compliance requirements for pass-through entities, you can make an informed decision to ensure proper reporting and maximize available tax benefits. Do you need to know how all this affects you? Let’s chat.