Pass-Through Taxation

When you start a business in the U.S., one of the most important decisions you’ll make is how that business is taxed. You may have heard of the term pass-through taxationbefore, but what does it actually mean? In this post we’ll go over what it means and how it affects your taxes.

What is Pass-Through Taxation?

Pass-through taxation is a tax structure where business income is not taxed at the business level. Instead, the income “passes through” to the individual owners, who report it on their personal tax returns.

This means the business itself doesn’t pay federal income tax. You file it personally on your own tax return. Think of the taxes passing through the business directly to you. 

This structure helps business owners avoid double taxation, which can happen when the IRS taxes both a company and its owners on the same income. 

What Kind of Businesses Use Pass-Through Taxation?

Most small and midsize businesses in the U.S. use the pass-through structure. Business structures include:

• Sole proprietorship – one owner, default tax setup
• Partnerships – two or more owners
• LLCs – can choose to be taxed as a sole proprietorship, partnership, or S corporation
• S corporation – special election required

C Corporations do not qualify. They pay corporate income tax, and their shareholders pay tax again on dividends (double taxation).

Real World Example

Let’s say you have an LLC that earns $80,000 in net income this year. If your LLC is a single-member entity:

• The LLC does not file its own income tax
• Instead, you report the $80,000 on your personal tax return using Schedule C
• You pay income tax (and likely self-employment tax) on it

If the LLC has two members, each owner receives a Schedule K-1 showing their share of the income to report on their personal return. 

Tax Benefits of Pass-Through Structures

1. Avoids Double Taxation: Income is only taxed once – on your personal return.
2. Qualified Business Income (QBI) Deduction: Many pass-through owners can deduct up to 20% of their qualified business income. In turn, this lowers your taxable income.
3. Flexible Entity Options: LLCs can choose the tax classification that benefits them most.

Keep An Eye Out For Hiccups

While mostly helpful, there are still a few things to look out for when choosing this tax structure.

1. Self-employment Tax: If you’re actively involved in the business, you’ll likely owe self-employment tax (currently 15.3%) on your share of the income.
2. Estimated Taxes: Because the IRS doesn’t withhold taxes from your income, you may need to make quarterly payments
3. S Corporation Rules: If you choose S Corp status to save on self-employment tax, you must pay yourself a “reasonable salary” and handle payroll.

A Note for Nonresident Business Owners

If you’re a non-U.S. citizen running a U.S. business through an LLC, pass-through taxation can get complicated. You may be required to file Form 1040-Nr, Form 5472, and other international-related filings, depending on your ownership and income source.

The IRS expects foreign owners to report U.S.-sourced income correctly, and the penalties for getting it wrong can be brutal. Make sure that the structure you pick fits your situational.

Thinking Your Structure Through

Pass-through taxation is a huge benefit for small business owners, freelancers, and entrepreneurs. It keeps taxes simpler and oftentimes more affordable. But like any tax setup, it’s not a one-size-fits-all.

Need help deciding the best way to structure your business taxes? We’re here to guide you through it. You can also head to the IRS website to get additional information here.