What are the benefits of pass-through taxation?

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.

What is a pass-through business?

Pass-through businesses encompass different business structures, each with different advantages and requirements, all of which require action by the owners.

Sole proprietorship

A sole proprietorship is the default business structure for a business owner with no partners. Freelancers and independent contractors who perform business activities and haven't filed paperwork with their state to become an LLC or incorporate are sole proprietors by default. Sole proprietors don't have to file separate tax returns for the business. Instead, the owner reporting the business' income and expenses on Schedule C, Profit or Loss From Business, attached to their personal tax return, Form 1040, U.S. Individual Income Tax Return, pays income taxes and self-employment taxes, along with state income taxes, if applicable.

Partnership

A partnership is the default business structure for businesses with more than one owner. Partnerships file a tax return using Form 1065, U.S. Return of Partnership Income. However, the partnership doesn't pay federal income taxes directly. Instead, each partner receives a Schedule K-1, which they use to report their share of the partnership's taxable income or loss on their personal tax returns.

Limited liability company (LLC)

LLCs take a little more effort to form than sole proprietorships or partnerships. Typically, members of the LLC need to file articles of organization and an operating agreement with their Secretary of State and pay a filing fee. LLC tax filing depends on whether the LLC has one member or multiple members. The IRS treats single-member LLCs as sole proprietorships for tax purposes, and the member reports business income and expenses on Schedule C, attached to the owner's Form 1040. Multiple-member LLCs file the same form used by partnerships: Form 1065. Each member receives a Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., reporting their share of the LLC's profits and losses.

S corporation

An S corporation, also known as a subchapter S corp, is a special tax status granted by the IRS. It allows organizations to take advantage of many of the same legal protections as a C corporation but be taxed like a pass-through business. S corporations file federal income taxes using Form 1120S, U.S. Income Tax Return for an S corporation. Each shareholder receives a Schedule K-1, which they use to report profits and losses from the business on their Form 1040.

What are the benefits of pass-through taxation?

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. Even though an entity may be a pass through certain states, such as California, have entity-level taxes.

Pass-through businesses avoid double taxation

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. C corporations are treated as a separate entity for tax purposes. This means that instead of the income passing through to the shareholders' personal tax return, the C corporation itself pays tax on net income. The C corporation can then give dividends to its shareholders from the net income of the business. These dividends received by the shareholders will be taxed again on the shareholders' personal tax return, thus subjecting the net income to double taxation.

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.

Pass-through businesses may claim the qualified business income deduction

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%. This 21% flat rate is set to expire in 2025. When it does expire, corporate income tax rates will return to graduated rates. 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.

A pass-through business structure provides flexibility

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:

• 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.
• An LLC can elect to be taxed like an S corp by filing Form 2553, Election by a Small Business Corporation, with the IRS.
• An S corp can change to a C corp by filing a written statement with the IRS, signed by a majority of the corporation's shareholders

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 adviser before settling on a particular business structure.