What Is Pass-Through Taxation?

pass through taxation

Your small to medium-sized business could benefit from pass-through taxation. You may have heard of it, but may wonder: what is pass-through taxation? Certain business entities are allowed to “pass through” tax liabilities for federal income tax purposes, leading to several benefits for business owners.

At the Parlatore Law Group, our skilled business formation lawyers understand this special tax benefit and how to put it to use for you. We work with new business owners and veteran-owned businesses to maximize the benefits they get out of their company, including the potential for pass-through taxation. We help you understand this benefit and how to get it.

Understanding Pass-Through Taxation

Pass-through business entities are not subject to a corporate income tax. This means that all of the imputed income passes through the business entity to the individual owners or members of the business. The business calculates its tax liability by calculating its net income, or gross income less its deductible expenses. Each owner then reports this business income on their tax return in the amount they receive.

Pass-through entities avoid the double taxation faced by large corporations. A corporation is taxed as a legal entity before its shareholders receive their income. Shareholders then pay tax again on the income they receive from the company. Pass-through organizations are not subject to this double taxation.

Types of Pass-Through Businesses

Pass-through businesses are those where the income passes directly to the owners, rather than being taxed at the corporate level. Common types of pass-through businesses include:

  • Sole Proprietorships: A business type that exists if you never form a legal entity for your company.
  • Partnerships: A business type of two or more partners who enter into a business agreement.
  • Limited Liability Companies (LLC): A business entity owned by members and who contract under an Operating Agreement.
  • S Corporations: Special incorporated businesses that meet specific IRS criteria and are permitted pass-through status for tax purposes.

Determining which pass-through business type is the right one for your business is an important decision. You should speak with a qualified business attorney who can analyze your unique needs and develop the right strategy for you.

Benefits of Pass-Through Taxation

The best benefit for you is the lack of double taxation. You should not have to pay twice for the income your business brings in unless you have to. Forming an LLC or other pass-through business type may be in your best interests for tax and other reasons. 

Owners of pass-through entities may also be entitled to a qualified business income (QBI) deduction. This deduction may be up to 20% depending on various circumstances. Your business attorney can further advise you on the tax benefits associated with your particular situation.

Disadvantages of Pass-Through Taxation

The main disadvantage of pass-through taxation is the possibility you will be taxed on income you did not receive. For example, unlike corporations, pass-through entities generally cannot defer tax on profits you would like to invest in the business later.

You may also be subject to a self-employment tax if you are not subject to a corporate tax. However, for many business owners this is still the better option because of their unique tax situation.

Understand Pass-Through Taxation With Business Formation Attorneys

At the Parlatore Law Group, we know what it takes to form your business and advise you about the tax options that work best. Our team provides an in-depth consultation and analysis of your company, your business goals, and much more to help you customize your path. 

Contact us today or schedule a consultation to learn more about pass-through taxation. We are ready to help.