For many U.S. startup founders, choosing the right legal structure is a foundational decision that impacts everything from liability protection to fundraising. Among the most popular choices are the Limited Liability Company (LLC) and the S-Corporation (S-Corp). A key reason for their appeal lies in their taxation method: pass-through taxation.

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At Lazo, we guide founders through the complexities of U.S. incorporation and tax compliance, ensuring they make informed decisions that support their growth. Understanding pass-through taxation is crucial for managing your startup's finances and personal tax obligations.

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📝 What is Pass-Through Taxation?

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Simply put, pass-through taxation means that the business itself does not pay income tax directly. Instead, the business's profits and losses are "passed through" to the owners' personal tax returns. The owners then pay taxes on their share of the business's income at their individual income tax rates.

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This is in contrast to a traditional C-Corporation, which is subject to "double taxation": the corporation pays tax on its profits, and then shareholders pay tax again on dividends received.

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💡 LLCs and Pass-Through Taxation

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By default, an LLC is treated as a pass-through entity for federal income tax purposes.

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• Single-member LLCs are taxed as sole proprietorships. The owner reports business income and expenses on Schedule C (Form 1040).
• Multi-member LLCs are taxed as partnerships. Each member receives a Schedule K-1, reporting their share of the LLC's income, deductions, credits, and losses. This income is then reported on their personal tax return (Form 1040).

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This simplicity is a major draw for many startup founders, particularly in the early stages, as it avoids the complexities and potential double taxation of a C-Corp.

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📊 S-Corps and Pass-Through Taxation

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An S-Corp is not a distinct legal entity but rather a tax election made by a corporation or, more commonly, by an LLC. To elect S-Corp status, a company must file Form 2553 with the IRS and meet specific criteria (e.g., must be a domestic corporation, have only one class of stock, and have no more than 100 shareholders).

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Like LLCs taxed as partnerships, S-Corps are also pass-through entities. Income and losses are reported on the owners' personal tax returns via a Schedule K-1.

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A key tax advantage of the S-Corp election, especially for startup founders who actively work in their business, is the ability to pay themselves a "reasonable salary." This salary is subject to payroll taxes (Social Security and Medicare). However, any additional profits distributed to the owners are typically not subject to these payroll taxes, potentially leading to significant tax savings.

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⚖️ Impact on Your Personal Tax Situation

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Understanding pass-through taxation is critical because it directly impacts your personal tax burden.

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• Tax Liability: Your share of the business's profits (even if not fully distributed as cash) will be included in your taxable income.
• Quarterly Estimated Taxes: As an owner of a pass-through entity, you are generally responsible for paying estimated taxes quarterly to the IRS to cover your income tax and self-employment tax obligations.
• Tax Planning: Effective tax planning becomes crucial. Founders need to forecast income and expenses to accurately estimate their quarterly payments and avoid penalties.
• Qualified Business Income (QBI) Deduction: Many owners of pass-through entities may be eligible for the Section 199A Qualified Business Income (QBI) deduction, which allows them to deduct up to 20% of their qualified business income, subject to certain limitations.

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✅ Key Considerations for Founders

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• Growth Trajectory: For startups planning significant venture capital fundraising and eventual large-scale exits, a C-Corp is often the required and most suitable structure due to investor preferences.
• Self-Employment Tax: LLC owners taxed as sole proprietorships or partnerships are subject to self-employment tax on their entire share of net earnings. S-Corp owners can strategically manage this by paying a reasonable salary.
• Compliance: Even with pass-through taxation, maintaining meticulous bookkeeping and accurate financial reporting is vital for correct tax filings.
• State-Specific Rules: While federal taxation follows pass-through rules, state-level tax compliance can vary. Some states may impose entity-level taxes on LLCs or S-Corps.

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🚀 Optimize Your Startup's Tax Strategy with Lazo

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Navigating the nuances of pass-through taxation and choosing the optimal incorporation strategy can be complex. You need a partner who understands the intricate balance between tax efficiency, legal compliance, and your startup's growth ambitions.

At Lazo, our experts provide end-to-end support for U.S. incorporation, tax setup, and ongoing compliance. We help founders like you:

• Choose the best entity type (LLC, S-Corp, C-Corp) for your specific needs.
• Understand and manage your pass-through tax obligations.
• Ensure seamless payroll setup and tax remittances.
• Gain clarity on international tax implications for foreign founders.
• Access essential banking services and financial tools.

Don't let tax complexities hinder your progress. Partner with Lazo to build a robust legal stack and focus on what you do best: scaling your startup.

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