Pass-Through Taxation 101
As a business owner, whether you have been a business owner for some time or you are just now starting your business, you have likely experienced many tax components. Initially, you have to choose the type of entity you want your business to be, but with that comes many other tax options. One of those is referred to as pass-through taxation.
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What Is Pass-Through Taxation?
To put it simply, pass-through taxation is where the tax is skipped over one entity and then passed to another. In other words it is passed through the business, allowing the business to refrain from paying that tax directly. It is then passed to another entity, which may be the owner, and that entity pays the taxes instead. The majority of small businesses operate using pass-through taxation because it comes with one major advantage, which will be discussed in a later section.
What Are the Types of Pass-Through Taxes?
While there are many different types of pass-through taxes, there are only really two that are encountered for small businesses: sales tax and business income tax.
- Sales tax – Sales tax is a tax on the sale of a product or service. The actual percentage of the tax is determined by the state in which your business does business. Every state has different rules and rates that businesses need to follow, so it is important that you check with your local laws. There are some states that do not enforce a sales tax; however, if you do live in a state where it is enforced, you will need to ensure that you manage your sales tax obligations. The benefit of these for the business is that business owners do not pay this tax. It is actually part of what the customer will pay in their total bill. The tax is not imposed on the business; you must collect it when you make a sale and then send the money to the government.
- Business income tax – Business income tax is the tax that is imposed on business income. This income is subject to taxes. However, the way around this is by passing the tax through the business and on to the owner. Instead of the taxes coming out of the business' income, the owner will pay these taxes on behalf of the business. They can do so by paying it with their personal tax return. The benefit of doing this for many people is that their personal tax rate is lower than the tax rate that is applied to their business income.
The Main Benefit of Pass-Through Taxes
Why do many small businesses utilize pass-through taxation? The answer is simple. When it is passed through, it is only taxed once. If small businesses do not utilize this tax method, then it is not just taxed when a customer makes a purchase of a product or service. It is then also taken through the business as it is added to the owner equity. This income must then have taxes taken out and distributed to the right agencies. When you compare the two, you see that pass-through taxation has a major advantage because instead of being taxed multiple times as income, it is only taxed once, and more money can remain with the business. Essentially, it prevents the income from double taxation where it is taxed at the business level and then again at the personal level.
Types of Pass-Through Tax Entities
Beyond pass-through taxation, there are also business entities that are designed to take advantage of this benefit automatically. With these types of entities, the business owners are able to pay the business income taxes on their personal income tax form. The following business entities are set up to be pass-through tax entities:
- Limited Liability Corporations (LLCs) – An LLC is a pass-through entity that brings together aspects of both a partnership and a corporation. These types of entities are owned by one person or more. If it is owned by a single individual, they will file their taxes as if they are a sole proprietorship (detailed below). When an LLC is owned by one person, it is treated by the IRS as a disregarded entity. That means that for tax purposes it is not viewed as a corporation. When an LLC is owned by two or more people, it is treated like a partnership when it comes to taxes. Unless the owners decide that they want to be taxed as a corporation, they will be taxed at the personal level.
- Partnerships – A partnership is owned by two or more people. As part of this entity, the owners all have part of the profits and losses that are associated with the business. This tends to be split equally, but may also depend on the agreement between the owners when it was created. This entity is set up in a way where the owners pay business income taxes depending on how much of the business they own. When someone owns more of a business, they also have to pay more of the taxes. However, because they do have to pay these taxes, they can do so on their personal tax returns instead of through the business tax returns. All partnerships use Form 1065 to show these losses and profits of the business to the IRS. Each of the partners use Schedule K-1 of that form and enter their share of the losses and profits of the business. They then put this information on their personal tax returns as well.
- S corporations – An S corporation is owned by a group of shareholders. There can be as many as 100 shareholders in an S corporation. The tax liability of each shareholder depends completely on the participation that they have in the business' activities. For this entity, all profits and losses are reported on Form 1120S. The shareholders of this business also complete Schedule K-1 in order to report their portion of the profits and losses of the business and use it to include the information on their personal tax returns.
- Sole proprietorships – In sole proprietorships there is one owner, or sole proprietor. As there is only one owner, that individual gets all of the business' income along with the business' debts. This includes the tax liabilities that are owed on the profits and losses. When reporting taxes, the entity will do so using the Schedule C form. They will attach this form to their personal income tax return and will pay for these taxes at the personal income tax rates.
What This Means for Your Business
On the surface, it is easy to see how important it is to choose the right entity for your business. You do not want to make a mistake of choosing the wrong one, because this decision has many tax implications. However, one of the biggest tax benefits is being able to pass these tax liabilities on to an individual. For your business this means many things, including generating more net income over time. Your business can enjoy the following advantages when utilizing pass-through taxation:
- You will generate more net income – This sounds good to everyone because the goal of any business is to generate a profit. However, it is not just about the amount that you can bring in through your business, but also how much you can keep at the end of the day. Taxes can take away a substantial portion of your income if it is taxed at the business level. However, being able to skip this part and pay taxes at the individual level lessens this impact and results in more net income.
- You can continue to build and invest in your business – Having more net income means that you will be able to do more for your business and continue to grow it. The more money you have, the more you can invest in new technologies, your employees, and more. You will be able to keep your employees happy by providing better benefits, and you will be able to keep your customers happy by developing more products or doing more to make the services that you provide better. You may still be able to do this without the higher net income, but it will be a lot more difficult.
- You will attract better outside funding – The funny thing about having more net income available from your business is that you will also be able to attract more outside funding. If this is something that you are interested in, then you can enjoy being able to find better options and use other people's money to invest in your business. If your business is struggling and does not have a healthy net income, you will have trouble finding someone who is willing to fund the business. On top of that, if you are looking for business loans, you will also tend to get lower interest rates.
- It will increase your company value and keep you in business – Having that money available when you need it will ensure that you will stay in business even during rough spots. Your net income should continue to increase over time and will allow you to have more flexibility in the financial department. Your business will continue to be able to function properly without running into any financial issues that cannot be covered by your accumulated funds. Additionally, as your net income increases, so does the value of your company. If you ever plan on going public, this is an essential component. Even if you do not want to go public but would like to sell your business one day, then you will be able to get more for the business if you have a high net worth.
- Owners will be able to keep more income – Not only will businesses be able to generate more net worth, but so will the owners of the business. Even though they are reporting the taxes for the business on their personal tax returns, because double taxation is prevented, they will also see an increase in their personal income every year. Instead of having the income taxed at the corporate level and then at the personal level, it is only done once and they can keep more of their money.
Proposed Tax Cuts on Pass-Through Entities
Pass-through taxes have been in the news lately because in the tax reform plan that has been proposed by President Donald Trump, there is a proposal for a cut to the top tax rate. You likely started hearing about this during the election, but now it is something that has the potential to become a reality. As part of this proposal, the top tax rate would be reduced from 39.6% to 15%. The corporate tax rate tops out at 35%, but pass-through entities do not pay this rate because they are taxed at the personal level. While many small businesses are set up this way, there are also many other types of businesses, such as private equity firms, hedge funds, major law firms, and even real estate developers. The partners in these businesses may pay up to 39.6% on their earnings even when they pay at the personal level. This would be a major change, and while it may not benefit all businesses that are set up this way, there may eventually be a shift in how businesses pay their taxes. Depending on when and if this is approved, there may be no reason to set up a business as a pass-through entity.
Only time will really tell how this will play out. Until that time, however, pass-through taxation and pass-through entities are an essential part of many businesses and how taxes are paid.