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What Is Pass-Through Taxation and What Types of Business Entities Allow It?

What Is Pass-Through Taxation and What Types of Business Entities Allow It?

woman working on taxes

Even if you’re still in the early stages of starting a business, it’s not too early to think about taxes — especially in terms of pass-through taxation. Your choice of business entity can affect the tax treatment of your business income, which can potentially save you thousands of dollars at tax time.

What Does “Pass-Through Taxation” Mean?

With pass-through taxation, the business’s income “passes through” to the business owner’s personal tax return, without having to owe corporate income tax. Sole proprietors and other small businesses are often set up as pass-through entities, with the owner’s business income treated the same as their own personal income.

Pass-Through Entity vs. Flow-Through Entity

“Pass-through entity” and “flow-through entity” are two terms that mean the same thing. Sometimes people will use the expression “flow-through entity” or “flow-through taxation” interchangeably with “pass-through.”

During the public discussion around the Tax Cuts and Jobs Act of 2017 that revised the U.S. tax code and took effect in 2018, there were a lot of references and media coverage of pass-through entities and what the tax implications would be for these businesses. (More details about that are included below.)

So for that reason, “pass-through” seems to be more commonly used than “flow-through,” and we tend to use “pass-through entity” more often here at Incfile. But “flow-through entity” or “flow-through taxation” is also technically correct.

For the purpose of this article, we mainly use “pass-through.”

The Advantages of Pass-Through Taxation

  1. Avoid double taxation
  2. Easier to file taxes
  3. Easier to keep track of your business income

Depending on your overall income, your marginal tax bracket and your overall tax considerations, pass-through taxation may be a good idea. For example, pass-through taxation can be an advantage compared to the way C Corporations (the most common type of corporate structure for big businesses and publicly traded companies) are taxed: C Corporations have to pay corporate income taxes and taxable dividends paid to the company’s shareholders. This is known as “double taxation.” Many business owners prefer to go with a simpler, lower-tax option for their small businesses and choose a pass-through entity instead.

Other advantages to pass-through taxation are that it can be easier to file your taxes and keep track of your business income. And you don’t need to be a sole proprietor to get pass-through taxation for your business income. There are a few types of business entities, such as LLCs and S Corporations, that can give you the advantages of pass-through taxation but also include some additional legal protections to make your business legitimate in the eyes of the government and protect your personal assets from some of the worst-case scenarios of doing business.

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Types of Pass-Through Business Entities

The following types of businesses are considered a “pass-through entity” for tax purposes:

Sole Proprietor

If you’re in business for yourself, by yourself, with no official corporate structure or business entity, you are a “pass-through entity,” and any of your business income will be reported on your personal tax return. You can’t file a business tax return if you don’t have a legal business.

Being a sole proprietor can be a simple way to do business, but it has some risks; you don’t have a legal business entity to protect your personal assets from lawsuits or liabilities, you don’t have a business bank account, you can’t borrow or build business credit and you might end up paying extra self-employment tax on your business income that could have been reduced with a different type of business entity.

LLC

If you form an LLC for your business, your LLC is also considered a pass-through entity for tax purposes. The LLC’s business income is not subject to corporate income tax; all of the LLC’s business income simply passes through to the owner’s personal tax return. If you are a solo entrepreneur with a single-member LLC, your taxes will be simpler than if you are an owner of a partnership with a multiple-member LLC; in that case, the partners’ shares of the business income need to be divided according to the partnership agreement, and the business owners will report the business income on their personal tax returns.

LLC pass-through income is treated basically the same as sole proprietor income; you might need to pay a higher share of self-employment tax unless you choose to file as an S Corporation.

S Corporation

An S Corporation is another form of business entity that has some unique advantages for tax purposes. If you set up an S Corporation for your business, you can take on business partners, investors or co-owners (up to 100 owners), as long as they are all based in the United States. S Corporations, like LLCs, do not have to pay corporate income tax; the S Corporation’s income is treated as pass-through income. Another advantage of an S Corporation is that it gives the business owner the option to pay themselves a reasonable salary, and then take the rest of the business income as a “distribution” from the business. But you only have to pay self-employment taxes on your salary, not the total amount of business income. This tax strategy can help you reduce your self-employment tax obligation and free up potentially thousands of dollars to save for retirement or invest in the business.

LLC Filing as S Corporation

Another option, if you own an LLC, is to elect to have your LLC file taxes as an S Corporation. Work with an accountant or tax professional to make sure you’re filing your tax returns the right way. But if you choose to do this, you can potentially save a lot of money on self-employment taxes while still receiving the advantages of pass-through taxation. Filing as an S Corporation means that you, as the business owner, can choose to pay yourself a reasonable salary, pay self-employment tax only on that salary amount and have the rest of your business income passes through to your personal tax return as a “distribution” that is not subject to corporate income tax or self-employment taxes. Use this free S Corporation Tax Calculator to see how this could work for your business.

How Can Pass-Through Taxation Save You Money at Tax Time?

Man holding $10 bill in outstretched hand

The Qualified Business Income Deduction

The new tax law that took effect in 2018 has some special provisions to give an extra tax break for small business owners who have pass-through entities. This is called the Qualified Business Income (QBI) deduction. With this deduction, pass-through entities (such as sole proprietors, LLCs and S Corps) can get an extra 20 percent deduction on their business income, with some limitations on types of income, up to a certain amount.

Depending on what kind of business you have, how you earn your income and how much household income you earn, this 20 percent deduction can be a major savings on your tax obligations.

But be aware that not all businesses can claim the full deduction — it depends on what type of business you own and what industry you’re in. The deduction phases out for higher-earning business owners in “specified service trades or businesses” (SSTBs) with incomes of more than $157,500 for single filers or $315,000 for married people filing jointly.

The SSTBs include professional services like accounting, actuarial sciences, law, healthcare, consulting, investing and investment management, performing arts or athletics. So if your business is involved with providing professional services, be aware that you might not get to claim the 20 percent deduction on your entire income if your income exceeds the threshold outlined above.

Talk with a tax professional to see if you can qualify for the Qualified Business Income deduction. This deduction is complicated, and more details are available on the IRS website. If you don’t already qualify for it, you may want to consider changing your business entity or file as an S Corporation to claim this deduction on next year’s taxes.

Pass-through taxation can be a simple, lower-cost way to manage your business income for tax purposes without the double-taxation of a C Corporation. If you are a sole proprietor doing business for yourself, with no legal business entity, your income will be treated as pass-through income for tax purposes. If you own an LLC or S Corporation, your business income will also receive pass-through taxation, but you will have additional legal protections for your personal assets. Make sure you understand the implications, talk with a tax professional and choose the right business entity for your needs.