On 10/22/24, the IRS announced that is has officially commenced operations of the newly established pass-through field operations unit within its Large Business and International (LB&I) division, which was announced last fall. This initiative aims to enhance the efficiency of audits conducted on pass-through entities. The establishment of a new unit dedicated to overseeing the compliance of pass-through entities of all types and sizes, including partnerships, S-corporations, limited liability companies (LLCs), sole proprietorships and trusts, signifies the IRS’s commitment to directing greater attention and resources toward a sector that has traditionally received insufficient scrutiny. Ensuring adherence to compliance and regulations for pass-throughs of all sizes and types is a crucial component of the broader enhanced enforcement initiatives aimed at high-income and high-wealth individuals. In the U.S., pass-through entities comprise 90% of all U.S. businesses for federal income tax purposes.
Pass-through entities
The IRS defines a pass-through entity as follows: “A pass-thru entity is an entity that passes its income, loss, deductions, or credits to its owners. The owners may be partners, shareholders, beneficiaries, or investors. It usually does not have an entity level income tax liability.” Meaning, these entities are exempt from corporate income tax. Their income is “passed through” to the income tax returns of the individual or corporate owners, where it is taxed according to their respective income tax rates. Pass-through entities are often utilized by higher-income individuals and can involve intricate and complex tax structures.
Why a Pass-through?
Pass-through entities offer several significant tax advantages compared to other business structures. The primary benefits are as follows:
- Avoidance of double taxation. Pass-through entities do not face double taxation, allowing owners to be taxed only once. The income generated by the business is reported on the owner’s individual income tax return and taxed at the applicable individual income tax rate. In contrast, C corporations are inherently subject to double taxation. They are required to pay a 21% federal business income tax before any profits are distributed to shareholders, who then must report any dividend income on their personal tax returns, resulting in a second layer of taxation.
- Net operating loss benefits. When a pass-through entity incurs a net operating loss (NOL), the tax liability of the owner could be reduced. The owner may be permitted to apply a NOL deduction on their personal tax return. Conversely, if a C corporation incurs an NOL, its shareholders remain obligated to pay income tax on any earnings they receive.
IRS Pass-through Strategy going forward
The integration of case-working expertise and the elimination of the entity-size barrier enable the IRS to enhance its audit rates in this domain, optimize workflows, and deliver a more uniform experience for taxpayers as noted below:
- Revenue agents in pass-through field operations will be assembled into geographically based teams that are responsible for primary exams of pass-through entity returns.
- LB&I will be responsible for starting pass-through exams, regardless of entity size.
- Small Business and Self Employes units will continue to examine pass-through entities as part of a related exam of a tax return.
Know this
Adherence to compliance and regulations for pass-throughs is key in order to avoid a possible audit.
If you are an owner of a Pass-Through entity, consult with your tax specialist. ©
