Benefits of Pass-Through Taxation

If you’re a small business owner — or you’re thinking of starting a business — tax time can be stressful. You might be wondering what pass through taxation is or how it can benefit you.

As crucial and complicated as taxes are, understanding the basics can take away some of the stress. In this guide, we’ll discuss the basics of pass-through taxation, including what it is, what entities it applies to, and its primary advantages.

What is pass-through taxation?

Pass-through taxation is an approach to income taxes that applies to the vast majority of small businesses (and some large ones). With pass-through taxation, a business entity actually doesn’t pay taxes at the business level. The business income tax burden “passes through” to the business owners. Each owner reports their share of the business income and loss on their personal tax returns.

As a result, business income from pass-through tax entities (sometimes called a flow-through entity) is taxed under personal income tax rates, not corporate income tax rates. This is as opposed to a typical corporation, in which the profits are taxed at both the business level AND the personal level.

How does pass-through taxation work?

Pass-through taxation can be a little tricky to navigate depending on your business, but its core tenets are relatively simple. Every year at tax time, a pass-through entity will determine whether or not it needs to file an informational return. Single-owner businesses, such as sole proprietorships and single-member LLCs, are disregarded entities and don’t file an informational return. Multi-member LLCs and general partnerships do file an informational return, Form 1065. This form doesn’t have any taxes due, though.

The owners of the business will use Schedule C (for sole proprietorships and single-member LLCs) or Schedule K-1 (for partnerships and multi-member LLCs) to report their share of the pass-through business income. If the business had any taxable gain for the year, each owner will pay personal income taxes on their share. In many states, this process repeats at the state level. That said, some states have different taxes, such as franchise taxes, that may apply instead of (or on top of) personal income taxes for business income.

Estimated Tax Payments

To avoid underpayment fees on April 15, many business owners will have to make quarterly estimated payments. Basically, the owner should estimate how much taxable income their business will probably make throughout the year. Based on that number, they can estimate how much income tax and self-employment tax they’ll owe. When they file their personal income tax returns, they’ll report all the estimated payments they made throughout the year.

Every quarter, the owner should make estimated payments based on their estimated tax liability. These payments are somewhat like the income an employer would withhold from their employee’s paycheck. The difference is that the business owner has to take care of that responsibility on their own.

Benefits of Pass-Through Taxation

A large number of businesses opt for a structure that gives them pass-through tax treatment simply because it has a lot of benefits. Let’s talk about the two primary advantages of being a pass-through business.

No Double Taxation

Double taxation is a term used to describe the two levels of taxation that occur when an entity is taxed like a C corporation. The income is, practically speaking, taxed twice. First, the business itself pays the corporate tax rate on its taxable gain. Then, after its shareholders receive their share of the profits, each shareholder pays personal income taxes on the gains they received.

Pass-through entities, however, don’t pay federal income taxes at the corporate level; they’re only taxed at the individual level. The business itself doesn’t pay federal income taxes (although it may file an informational return). The tax burden falls on each individual member. In many cases — but not all — single taxation creates a lower overall tax burden.

Qualified Business Income Deduction

As part of the 2017 Tax Cuts and Jobs Act, lawmakers introduced the Qualified Business Income Deduction for pass-through entities. This deduction allows some small business owners to deduct up to 20% of their business income from their total personal income. Some real estate investment trust income and dividends from certain partnerships can also be deducted (on top of the initial 20%).

The “terms and conditions” for making this deduction can be a little bit complicated. If you’ve never made this deduction before, we recommend consulting with a licensed attorney or CPA.

Entities with Pass-Through Taxation

There are four different types of businesses that enjoy pass-through taxation.

Sole Proprietorships

A sole proprietorship is an unincorporated business entity owned by a single person. If a single entrepreneur starts a business without registering with the state — which is legal, as long as they have any necessary business licenses — they’re a sole proprietorship. This category also includes gig-based workers, like freelancers and independent contractors. Sole proprietorships are very simple to start and run, but they don’t offer personal asset protection.

For federal income tax purposes, sole proprietors are classified as disregarded entities. The business itself doesn’t file a tax return at the entity level. The owner uses Schedule C of IRS Form 1040 to report their business profits and losses.

General Partnerships

A general partnership is an unincorporated business entity owned by two or more partners. Generally speaking, business partners don’t file any formation documents with the state (with the exception of any required business and professional licenses). Like sole proprietorships, general partners don’t have limited personal liability for their business activities.

For federal income taxes, general partnerships have to do a little more legwork than sole proprietors. They have to file Form 1065, the Partnership Return of Income. This is an informational report, and each partner will corroborate it by filling in Schedule K-1 at tax time to report their share of the business’s profits and losses for the year.

LLCs

LLCs, or limited liability companies, are business entities that register with their Secretary of State by filing the Articles of Organization. They can be owned by one or more owners (called members). Like corporations, LLCs enjoy limited liability protection. But compared to corporations, LLCs are relatively easy to run and maintain.

S Corporations

Technically speaking, an S corporation is not an entity type. It’s a tax classification created by Subchapter S of the tax code. Certain domestic corporations and LLCs can qualify to become an S corporation by filing Form 2553 with the IRS.

If an eligible entity elects S corporation status for federal tax purposes, it’s taxed like a pass-through entity. That said, its business structure does not change. S corporation status can also help members reduce their self-employment tax burden, but this varies depending on the business.

It can be tricky to determine if electing S corporation status will or won’t reduce your tax burden, so we highly recommend consulting with a business attorney.

We can help!

Thinking about starting a pass-through business, but not sure where to start? ZenBusiness has your back. Our LLC formation service makes it easy to create your limited liability company. And we don’t stop there. Whether you need a streamlined money app to manage your finances, a registered agent for service of process, or help filing your annual report, we can help.