One of the main tax benefits of electing a pass-through business structure is avoiding double taxation. Business earnings are only taxed once, on the owner or shareholder's personal tax return.
updated November 29, 2023 · 4min read
One of the first decisions every business owner makes is how to structure their business.
This actually involves two separate decisions. First, you have to decide on the best legal structure for your business. Then you need to decide how the business should be taxed.
When it comes to taxes, most small business owners choose a pass-through business structure. In fact, 95% of businesses in the U.S. are pass-through businesses, largely due to the benefits of pass-through taxation.
Pass-through businesses encompass different business structures, each with different advantages and requirements, all of which require action by the owners.
A business owner's choice of business entity can affect how a business files tax returns and pays taxes. But there are other potential tax advantages of choosing a pass-through business structure over incorporating.
The earnings of a C corp. are taxed twice: once on the corporation's tax return and again on shareholder tax returns when the corporation distributes profits to shareholders in the form of dividends.
Pass-through businesses don't have to deal with double taxation. Instead, the company's revenues and expenses “pass-through" to the business owner's tax return, where the owner pays tax on profits or deducts losses along with their other personal income and expenses.
The Tax Cuts and Jobs Act (TCJA) of 2017 reduced the corporate tax rate from a maximum rate of 35% to a flat rate of 21%. Small business owners pushed back against early drafts of the legislation, arguing that the law favored big businesses—which are more likely to be structured as C corporations—over small businesses, which are most often structured as pass-through entities.
In response, lawmakers added a new tax break for pass-through entities: the Qualified Business Income Deduction, allowing certain pass-through businesses to deduct up to 20% of qualified business income (QBI).
Determining whether a business qualifies for the QBI deduction and calculating the deduction is complicated. The law limits the deduction for certain types of service-based businesses and includes limitations based on the owner's total taxable income, qualified property, and W-2 wages. For that reason, it's a good idea to work with a tax attorney, accountant, or enrolled agent to understand how the QBI deduction applies to your business.
Another benefit of selecting a pass-through tax structure is flexibility. If you've outgrown the tax advantages of your current business structure, you may be able to change to one that's a better fit. For example:
Of course, tax benefits aren't the only factor in selecting a business entity. Not only does this decision impact how a business pays taxes, but it also impacts the amount of paperwork required, the personal liability of owners and shareholders, and the organization's ability to raise money from outside investors. For that reason, it's important to consult with an attorney or tax advisor before settling on a particular business structure.
by Janet Berry-Johnson
A freelance writer with a background in accounting and income tax planning and preparation for individuals and small ...
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