You read that correctly. Just the words pass-through get your attention and stir the imagination. Does a pass-through business mean business owners leap over hurdles or go through valleys to reach mountaintops? Well, in a way that’s true.
A pass-through business gets around tax requirements corporations face when confronting double taxation. This post details how pass-through businesses work, how they pay taxes, and which types of businesses are pass-through entities. This article will help you decide if a pass-through business is right for you.
What Is a Pass-Through Business?
As the name implies, income, business deductions, credits, and losses, pass through to the individual owner or owners of a business. The individuals report their profit or loss on their personal tax return along with other income. Examples of other income include wages paid as an employee, interest earned, IRA distributions, social security benefits, etc.
What Does It Mean as Far as Paying Taxes?
Actually, operating as a pass-through entity could result in significant tax savings.
When business owners of these businesses pay individual income tax on taxable income, they aren’t subject to paying corporate taxes. On the other hand, a C-Corporation pays tax on earnings and the owners pay tax again on the dividends paid on the same earnings reported as income. This is referred to as double taxation. Moreover, corporation owners are also taxed on any sold stock that realizes a capital gain.
That’s how a pass-through entity saves owners money. They’re only taxed once. For example, a business has two owners and their earnings before taxes jointly total $300,000. Keep in mind, this is net income available to the owners but it doesn’t have to be distributed in order to be taxed. In this scenario, each business owner reports $150,000 as income on Schedule C separately on their individual tax returns and are taxed accordingly. However, since their businesses aren’t corporations, no dividends were paid to them so they don’t owe additional tax.
Don’t forget that business income that passes through to an individual may be subject to self-employment tax which is currently 15.3% of net earnings after business expenses and adjustments are deducted. Business owners who send in estimated tax payments to cover projected federal income tax also submit SE tax at the same time.
What Types of Businesses are Pass-Through Entities?
The following types of businesses do not pay corporate tax. In some instances, limited liability corporations are considered pass-through entities.
- Sole Proprietorship: This unincorporated business is owned by one owner or a married couple. Profit or loss from the business is reported on Schedule C and transferred to the individuals or couple’s 1040 tax return. The Self-Employment Contributions Act requires sole proprietors to pay self-employment tax.
- Partnerships: Multiple owners share the assets and liabilities of the business. They report their share of income on Schedule E reported on Form 1065, U.S. return of partnership income. Some limited liability corporations elect to be taxed as a partnership. What’s more, full partners pay self-employment tax; whereas limited partners only pay SE tax when paid for labor services.
- S-Corporations: Subject to owning a single class of stock and 100 shares, S-Corporations file a corporation tax return. Profits flow to shareholders’ personal tax returns. Shareholders receive compensation that’s required to have FICA tax withheld. However, S-Corp shareholders do not pay SE taxes.
Generally, sole proprietorship and partnerships are easier to set up because each state doesn’t require you to file any documents. Conversely, LLCs are usually required to file articles of organization and S-Corps articles of incorporation. Depending on what state you live in, authorities may require operating agreements from LLCs and bylaws from S-Corporations.
This general information about pass-through entities in no way overrides the expertise gained by contacting an accountant or tax professional. They know the tax code inside and out and how to maximize a business’s profits and minimize taxable income.
Is a Pass-Through Business Right for You?
A business owner must weigh the pros and cons before deciding on whether a pass-through entity is the best choice.
Pros of a pass-through business
A pass-through entity enables owners to pay a more favorable tax rate and be protected from personal liability. One of the more obvious reasons to choose a pass-through business structure is to avoid double taxation on business assets. Business owners want to make money and it seems unfair to watch profits dwindle due to taxation.
Implemented in 2018, The Tax Cuts and Jobs Act passed a tax reform allowing pass-through entries to claim a 20% deduction on each owner’s share of business income to reduce the federal income tax owed. Taxpayers must fall within an income limit and meet specific requirements to qualify for the deduction.
Furthermore, a pass-through business isn’t limited to size. There are single-owner businesses and ones that have hundreds of employees. Typically, a pass-through business earns more net income than a corporation.
Pass-through business owners can pay 20% less tax on their business income than employees pay on their wage income.
Cons of a pass-through business
Depending on your income stream, your personal tax rate could be as high as 37% (with income more than $510,300 for single filers and $612,350 for married couples). According to the most recent IRS federal tax brackets, other tax rates range from 10% to 35% ($9,700 – $204,100 single filers and $19,400 – $408,200 married couples).
Individual tax code continually changes as lawmakers review how pass-through entities affect tax revenue. Moreover, when setting up a pass-through entity you may need to pay for the services of an accountant and attorney.
Sometimes owners have more difficulty raising investor capital unless they structure their businesses as a C-Corporation.
Getting It Right
Choosing a business structure determines how you file taxes and your legal liabilities. The right one complements the vision you have for your company. In other words, your business structure enhances the way you like to do business and helps you keep as much of your hard-earned profit as possible.