Pass-through Taxes and Business Owners

Pass-through Tax and Business Owners
Pass-through Tax and Business Owners. Image Source/Getty Images

You may have heard the term "pass-through" as it relates to business taxes and wondered what it meant. Most small businesses have pass-through taxes.

Pass-through Taxes and Business Types

Pass-through tax treatment means that the taxes of a business are "passed through" to the tax return of the individuals owning the business. Sole proprietorships, partnerships, most LLC's, and Sub-chapter S corporations qualify for pass-through status.

Pass-through status also means that these business entities are not subject to double taxation, as are corporations.So, the opposite of pass-through would be corporate taxes. Taxes for corporations aren't pass through because corporations are separate entities from their owners. 

How Pass-through Businesses are Taxed

Because the taxes of the business are passed through to the owners' tax returns, the business profit is taxed at the individual owner's personal tax rate, rather than at the corporate tax rate. This difference may result in a lower - or higher - tax rate for the business, depending on the tax rate of the individual taxpayer. 

Pass-through Taxes and  Sole Proprietorships

In a sole proprietor business, the business and the business owner are not separate, from a tax standpoint. The business tax filing is part of the business owner's personal tax return. So the profits or losses are calculated on Schedule C of the owner's personal 1040 and the net income or loss is passed through to Line 12 of Form 1040, for the owner.

 

Single-member LLC's pay income tax in the same way as sole proprietorships, so income tax is passed through to them in the same way. 

Pass-through Taxes for Partnerships and S Corporations and LLC's

In other types of businesses that are not corporations, the tax liability of the business is passed through to the owner's personal tax return in a different way.

 

For a partnership, for example, the net income (profit) of the partnership as a whole is calculated. Then, this income (or loss) is divided among the partners according to their distributive share, as set in the partnership agreement. Each individual partner receives a Schedule K-1, which shows their share of the profit, and which is included in the person's Form 1040. 

Members of a multiple-member LLC are taxed as partners, so they would receive a partnership K-1 based on their share of the profits of the LLC. 

In the same way as the partnership, S corporation owners also receive a Schedule K-1 showing their share of the profits of the S corporation for the tax year. 

Pass-through Taxes and Self-employment Tax

Although self-employment tax (Social Security and Medicare tax for self-employed individuals) is not directly related to pass-through taxes, the amount of self-employment tax is calculated based on the business owner's net income, and it is passed through to the individual income tax return to be paid. in the case of self-employment tax, the tax is not paid by the business, but by the individual, since it relates to the individual's Social Security and Medicare benefits.