Pass-through taxation is a tax structure where the owners or shareholders of a business receive profits and losses and report them on their tax returns; the business entity itself doesn’t pay tax, avoiding double taxation at a corporate level.
The pass-through tax structure has advantages and disadvantages, and we’ll look at those in this post so you can decide if pass-through taxation is the right choice for your business.
Thinking about opening an LLC? Pass-through taxation is a key concept for all business owners, regardless if you plan to open an LLC. learn all about it in this comprehensive guide.
Pass-through entities, also called flow-through (FTE) or fiscally transparent entities from a tax perspective, are classified as “non-entities” since they don’t pay tax.
Here’s how it works:
When your business makes a profit, it avoids federal income tax because of the pass-through structure; instead, you calculate your taxes relative to your income tax rate and report what you owe on your personal tax return using (Form K-1 (or Schedule K-1).
Pass-through businesses include several structures with benefits, set-up, and running requirements.
Sole proprietorships are the easiest business structure for solo entrepreneurs. Anyone who does business without forming an entity is a sole proprietor by default.
Sole proprietors report their income and expenses on Schedule C, Profit or Loss From Business, attached to their tax return (Form 1040, U.S. Individual Income Tax Return), avoiding federal corporation tax.
Partnerships, a (non-registered entity with 2 or more people), the business doesn’t pay federal income taxes.
Instead, partners pay their percentage portion of taxable income using Schedule K-1, ensuring taxation occurs at the individual rather than entity level.
LLC formation requires additional steps compared to a sole proprietorship or partnership. LLC members must file articles of organization with their Secretary of State, pay a filing fee, allocate a registered agent, and sometimes write and submit an operating agreement. How an LLC pays tax depends on the number of owners.
For example:
Single-member LLCs are treated as sole proprietorships for tax, with the owner reporting their profits and losses on Schedule C attached to their Form 1040.
Multiple-member LLCs are similar to partnerships for tax and file Form 1065. Members receive a Schedule K-1, which they use to report their share of the LLC’s profits.
An S corporation has unique tax status that enables businesses to benefit from similar legal protections as C corporations and pay tax as pass-through entities.
S corporations pay federal income taxes and file them using Form 1120S. Shareholders use a Schedule K-1 to report their income on Form 1040.
A C corporation pays income tax on its corporate earnings, then distributes taxable dividends to shareholders who pay personal tax relative to their income status, creating double taxation.
A key benefit to a C corporation is leaving profits (reinvest) in the business, avoiding tax.
Pass-through taxation offers several benefits; some can affect the amount you can reinvest in your business, and others make life easier come tax time.
Pass-through taxation simplifies the tax process by removing the need for federal corporation tax. Instead, you report your share of profits or losses you take from your business on your tax return, streamlining the overall tax compliance process.
Pass-through businesses can avail of business income deductions, allowing you to lower your overall tax liability.
Your main deduction could be the Qualified Business Income Deduction (QBI), which allows you to deduct 20% of your qualified income from your tax bill.
To determine whether your business qualifies for any of the below deductions, speak with a tax accountant or attorney.
Deductions include:
Pass-through business structures have a flexible ownership structure and fewer regulatory requirements than corporations. Allowing you to customize your operations, like profit sharing and adaptable ownership arrangements.
Another pass-through benefit is upgrading your business structure as your brand grows.
For example:
Pass-through entity owners that experience a loss can offset it against other income on their tax returns, reducing their overall tax liability.
Pass-through entities have more straightforward formation and operational requirements than corporations.
Business owners of pass-through entities pay self-employment taxes, which are higher than regular corporations, except S corp shareholders, who can take a taxable wage and further no-taxable dividends.
Unlike s corporations, other pass-through entities cannot keep business profits at a lower tax rate. Instead, profits pass through to owners who pay the going tax rates, limiting the ability to reinvest earnings into the business.
Some professional service providers, such as lawyers and doctors, cannot claim the qualified business income (QBI) deduction above an income of $232,100 if single and $464,200 if married and filing a joint tax return.
S corporations can issue stocks and shares to attract investors; other pass-through entities cannot.
The one exception is an LLC or LLP can sell percentage ownership to raise funds.
Remit means a tax you collect on behalf of the government and pass it on. So you only pay what you collect.
Payable taxes are those due on your business profits and vary depending on your location and income.
As a pass-through entity business owner, you may need to file additional taxes:
Sellers of products must collect and remit a sales tax relative to their state’s rates.
Fortunately, you don’t pay sales tax from your income. Instead, sales tax is a percentage of your customer’s total bill. You collect it at the point of sale and then remit it to the government.
Pass-through taxation means tax liabilities associated with your business income pass through to you and are payable on your tax return relative to your tax rate.
Pass-through entity business owners pay self-employment taxes, which include Social Security and Medicare taxes, based on their net earnings.
And businesses with employees must keep a percentage of Social Security, Medicare, and federal income taxes from their wages, which they remit to the IRS.
Depending on your business’s location, your pass-through entity might be subject to various state and local taxes, such as sales, property, excise, or franchise.
Most pass-through entities must make estimated quarterly tax payments to ensure their business meets its tax obligations on time.
Pass-through entities include S corporations, limited liability companies (LLCs), limited liability partnerships (LLPs), limited partnerships, general partnerships, and sole proprietorships.
According to U.S. federal income tax laws, certain business entities can pass-through profits to their owners.
Yep, pass-through taxation.
As a result, the owners report and pay taxes on the income or deduct losses on their tax returns.
Many small business owners prefer the S corporation structure because of its tax advantages, which avoid corporation tax and allow you to take employment tax-free dividend payments.
Pass-through taxation simplifies tax compliance, prevents double taxation, and allows for deductions and tax benefits. However, owners pay self-employment taxes and limit their ability to keep profits within their business.
Pass-through taxation for LLCs means the company’s profits “pass-through” to the individual owners, who report them on their tax returns. The LLC itself doesn’t pay federal income taxes, preventing double taxation.
Members pay taxes on their share of the LLC’s income based on their ownership percentage, providing the benefits of pass-through taxation while maintaining limited liability protection.
The benefit of pass-through taxation is its simplicity and avoidance of double taxation.
With pass-through taxation, the business itself does not pay federal income taxes. Instead, the profits and losses “pass through” to the individual owners, who report them on their tax returns. This streamlined approach eliminates the need for a separate tax return at the entity level and reduces administrative complexity.
A partnership earns $100,000 in profits during a tax year. Instead of the business paying taxes on that $100,000, the income passes through to the individual partners. Each partner then includes their share of the profits on their tax returns and pays taxes at their relevant tax rates.
Tax benefits of pass-through taxation are just one of the factors to consider when choosing a business structure. Others include ease of formation, paperwork, running costs, liability protection, and the ability to raise funds.
Fortunately, pass-through businesses are flexible.
You could start as a non-legal entity (like a sole proprietorship or general partnership) and consider LLC formation as your brand grows.
The takeaway from “What is Pass-Through Taxation” is it makes life easier for most small business owners.
This portion of our website is for informational purposes only. Tailor Brands is not a law firm, and none of the information on this website constitutes or is intended to convey legal advice. All statements, opinions, recommendations, and conclusions are solely the expression of the author and provided on an as-is basis. Accordingly, Tailor Brands is not responsible for the information and/or its accuracy or completeness.
Terry is a serial entrepreneur with over 25 years of experience building businesses across multiple industries – construction, real estate, e-commerce, hotelier, and now digital media. When not working, Terry likes to kick back and relax with family, explore Taoism’s mysteries, or savor the taste of fine Italian red wine.
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