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.
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.
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.
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.
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:
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:
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.