Pass-through taxation is a tax structure where the company's profits and losses are not taxed at the business level but "passed through" to the owners, who report them on their individual tax returns and pay taxes accordingly.
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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.
The simple definition of pass-through taxation (or flow-through taxation) is that it’s a tax treatment that allows all income, losses, credits, and deductions of a business to pass through to the owner or owners. When the business makes a profit, the entity itself doesn’t pay tax on its income. Instead, it passes the income through to the business owners, who pay income tax on the profits. The owners report the income on their personal tax returns and calculate their taxes according to their personal income tax rate.
In contrast, double taxation is another type of tax treatment that taxes the same income twice. If a C corporation generates income, that legal entity pays income tax on its earnings at both the corporate level and the individual level. First, the corporation pays taxes on its corporate income. Then, it passes dividends down to the shareholders, who pay tax again on their individual tax returns.
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” to the IRS 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. Read the franchise taxes definition.
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.
Many businesses opt for a structure that gives them pass-through tax treatment simply because it has many benefits. Let’s discuss the two primary advantages of being a pass-through business.
Double taxation is a term used to describe the two levels of taxation that occur when an entity is taxed like a What is 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.
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.
We mentioned that pass-through taxation might not be for everyone, so let’s look at the reasons for this. First, reporting business profits on your personal return could put you into a higher tax bracket. You may actually end up paying more taxes than if your business was subject to double taxation.
Another potential disadvantage of a pass-through entity is that it may be difficult to attract investors. Often, investors like corporations because they have stricter requirements.
There are four different types of businesses that enjoy pass-through taxation.
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 more information please see: What is a Sole Proprietorship?
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.
A general partnership is an unincorporated business entity owned by two or more partners (see general partnership definition). 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, 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.
Technically speaking, an S corporation (please see our What is an S Corp? page) 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 or qualified accountant.
With pass-through taxation, your business doesn’t pay income taxes on its profits. Instead, the owners report the company’s income on their personal tax returns. They can also include all business credits, losses, and deductions on their return.
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Is pass-through taxation good or bad?
Pass-through taxation is usually a good thing because it means that your business’s profits are only being taxed once, at the individual business owner level. The alternative is “double taxation,” which is what a typical corporation has. With double taxation, the profits are taxed twice, first at the business level and again when they’re distributed to the individual business owners.
How does the pass-through deduction work?
There are actually lots of different tax deductions available to pass-through business owners. The Qualified Business Income tax deduction lets you deduct up to 20% of your business income from your total earned income. Then there are deductions you can take for auto expenses related to your business, the cost of equipment, the cost of business education, and much more. Check out our LLC deductions page to learn more.
What are the cons of pass-through taxation?
The biggest drawback to pass-through taxation is arguably self-employment taxes. When an LLC is taxed like a pass-through entity, its members have to pay employment taxes (contributions to Social Security and Medicare). Normally, when an employee receives a paycheck, the employee and the employer both pay half of the employment tax burden. But self-employed individuals — including LLC members — have to pay the whole amount themselves.
This drawback might not apply as heavily to S corporations, though. That’s because S corporations can pay their members in two ways. First, they can pay members like employees with a “reasonable salary.” Salary income will be subject to employment taxes. Second, they can distribute any remaining profits as member distributions, which aren’t subject to self-employment taxes. This can (but doesn’t always) reduce an individual’s overall tax burden.
If you’re unsure if S corp status would benefit you, we recommend consulting with a licensed tax advisor.
Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
Written by Team ZenBusiness
ZenBusiness has helped people start, run, and grow over 700,000 dream companies. The editorial team at ZenBusiness has over 20 years of collective small business publishing experience and is composed of business formation experts who are dedicated to empowering and educating entrepreneurs about owning a company.
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