A pass-through business is a sole proprietorship, partnership, or S corporation thatis not subject to the corporate income tax; instead, this business reportsits income on the individual income tax returns of the owners andis taxed at individual income tax rates.
Howis a C Corporation and a Pass-through Business Different?
While corporations are legally separate from their owner(s), pass-through businesses are legally synonymous with the individuals who own them. In the tax code, corporations pay tax at both the entity level and again when they distribute earnings to their shareholders. By contrast, pass-throughs simply shift their gains or losses to the owners or employees, who then report the income to the IRS and pay tax accordingly. That means that pass-through businesses pay individual income taxes, not corporate income taxes.
The vast majority of companies in the United States are pass-through businesses: 28.3 million out of the 30.8 million private business establishments that operated in the United States in 2014. Pass-through businesses account for over half of business income in the United States and employ over half of the private-sector workforce.
How Does Pass-through Taxation Work?
When a pass-through business earns profits, it does not directly send a portion of the profits to the Internal Revenue Service (IRS). Instead, the profit is “passed through” the business and onto the tax returns of the business owners. To determine their liability, the business first calculates its net income, or gross income less deductible expenses (see Sec. 199A expenses). Then, each person includes their portion of the business’ net income on their tax return. For a sole proprietorship, the tax is calculated on the owner’s total net income. In a partnership or S corporation, the tax is determined by percentage share of net profit.
What Other Kinds of Taxes Do Pass-throughs Have to Remit?
Pass-through businesses also pay self-employment taxes and state and local taxes. Many pass-throughs (especially sole proprietorships) must calculate their Social Security and Medicare taxes as “self-employment taxes.” In pass-throughs with multiple employees and owners, owners are required to calculate their own payroll tax liability, both on the employer and the employee side. That is, pass-throughs must pay a 6.2 percent tax on their earnings and withhold 6.2 percent of their employees’ wages at each pay period.
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FAQs
A pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates.
What is an example of a pass-through business? ›
Pass-through businesses include sole proprietorships, partnerships, limited liability companies, and S-corporations. The share of business activity represented by pass-through entities has been rising for several decades.
What does pass-through mean in LLC? ›
In virtually all cases, LLC are treated with what's known as “pass-through taxation.” This means that the LLC does not file its own corporate income taxes. Instead, after the LLC pays its bills and debts, the members collect its remaining revenue and pay taxes on that income.
What is the benefit of a pass-through entity? ›
The main benefit of pass-through taxation is that your business entity is not subject to double taxation. Meaning you don't pay tax twice (at the corporate and personal level) on the same source of income. By comparison, traditional corporations are subject to double taxation.
How does a pass-through work? ›
What is a pass-through entity? A pass-through entity, also known as a flow-through entity, is a business entity in which the profits pass through to the owner(s) of that business and are taxed at the individual tax rate. In other words, this business type is not subject to federal income tax.
What is the difference between a pass-through entity and an LLC? ›
Limited liability companies (LLCs) are what's called "pass-through entities." This means that the business does not pay corporate income taxes. Instead, the individual owners or members of the LLC collect its proceeds as income and then pay personal income taxes on the results.
What is a pass-through cost in business? ›
Cost pass-through arises when a business changes the prices of the products or services it supplies following a change in its costs.
What is the difference between a pass-through entity and a C Corp? ›
A C corporation pays entity-level income tax and then shareholders pay tax on dividends — and on capital gains when they sell the stock. For pass-through entities, there's no federal income tax at the entity level.
What is a qualified pass-through entity? ›
A qualifying PTE is an entity taxed as a partnership or S corporation.
Is a pass-through entity an S Corp? ›
An S corporation is a corporation that elects to be taxed as a pass-through entity. Income, losses, deductions, and credits flow through to the shareholders, partners or members. They then report these items on their personal tax return. IRS approval is required for the S election status.
Pass-Through Entity Pros and Cons
- Launching a business is easier for certain pass-through entities, especially sole proprietorships and general partnerships.
- Pass-through entities can avoid double taxation.
- The tax structure is more equitable, passing a higher tax burden onto owners who are at higher tax brackets.
Pass-through income is only subject to a single layer of income tax and is generally taxed as ordinary income up to the maximum 37 percent rate. However, certain pass-through income is eligible for a 20 percent deduction, which reduces the top tax rate to a maximum of 29.6 percent.
How does LLC avoid double taxation? ›
LLCs avoid double taxation because they are a pass-through entity—there is no tax on profits at the LLC level, only at the individual member level.
What happens if my LLC loses money? ›
LLC losses are beneficial because they can offset business income, effectively reducing the LLC's tax liability. Let's say an LLC had $100,000 in business income but incurred $30,000 in losses; these losses could reduce the taxable income to $70,000. Claiming business losses can reduce your tax liability.
Do LLC losses pass through? ›
If your business is a partnership, LLC, or S corporation shareholder, your share of the business's losses will pass through the entity to your personal tax return. Your business loss is added to all your other deductions and then subtracted from all your income for the year.
Does an LLC pay capital gains tax? ›
If an LLC is listed as a C Corporation, the LLC must file corporate income taxes. In 2022, the federal corporate income tax rate is 21%, with many states adding their own taxes on top of that. Along with the corporate income tax, any profits or dividends distributed to members are subject to capital gains tax.
What is an example of a pass-through revenue? ›
Pass-Through Revenue means, for any given period, any revenue related to any Craigslist fees, any eBay account fees and any other third party fees “passed through” to AutoNation, Carvana, Vroom and/or any other Person, as applicable, by the Company, the Business and/or Buyer, as applicable, which, for the avoidance of ...
What is an example of a pass-through account? ›
The usual example of this is sales taxes, where you'd collect the sales tax on behalf of the applicable government, and then remit the tax to them – usually once a month, but sometimes less frequently.
What is a pass-through cost example? ›
It's also important to note that pass-through costs can be either recurring or non-recurring, such as a monthly standard delivery charge or a charge to disconnect electricity service.
What is an example of a pass-through taxation? ›
A pass-through business structure provides flexibility
For example: Sole proprietorships and partnerships can file paperwork with the state to become an LLC. An LLC can elect to be taxed like a C corp by filing Form 8832, Entity Classification Election, with the IRS.
