A pass-through entity is any entity in which the income and losses from operations pass through the entity level and down to the partners or members who are ultimately taxed on that income. These pass-through entities include partnerships, S-Corporations, and single member LLCs.
State-Level Tax Election for Pass-Through Entities
States have enacted legislation to allow partners and members of these entities to elect to pay state income tax at the entity level. The intention is to allow individuals to circumvent the federal $10,000 state and local income tax deduction cap.
Under the new Virginia tax legislation, a qualifying pass-through entity may make an annual election to pay an income tax at a rate of 5.75% at the entity level for taxable years 2021 through 2025.
Unfortunately, Virginia requires all the tax partners to be natural persons or entities disregarded for federal tax purposes.
The enacted Virginia law creates a pass-through entity tax for partnerships and S corporations owned 100% by individuals. Draft guidelines were released in October 2022. Taxpayers may benefit if they have over $10,000 in state and local taxes and own a partnership or S corporation. The election is due by March 15th for calendar year entities.
Benefits of Pass-Through Entity Tax
Pass-through entity tax helps reduce double taxation, since the income is only taxed once.
The Qualified Business Income Deduction allows pass-throughs to deduct up to 20% of income.
Thirty-six states and New York City have enacted pass-through taxes, each a little different. Some states have expanded eligibility or changed from mandatory to elective pass-through taxes.
Most states set pass-through taxes at their top individual rate.
Pass-through status remains advantageous for asset sales, with gains taxed once at the owner level.
Pass-Through Entities
- How owners get paid
- Tax treatment
- 2017 Tax Cuts and Jobs Act impact
- Advantages and disadvantages
Owners get paid regardless of distributions. Profits are allocated to owners for taxes. Some states impose taxes like franchise fees. Owners owe self-employment taxes on pass-through income.
These structures avoid double taxation. In 48 states, pass-throughs employ most of the private workforce. They account for 40% of private payroll, especially in services.
Although pass-throughs don’t pay income taxes, they often file returns. Like profits, losses reduce overall owner tax liability.
Benefits of pass-through entities:
- Simple structure combining personal and business income
- Profits only taxed once at owner rates
Tiered ownership structures allow asset protection and tax advantages for pass-through owners.