Pass-through Taxes and Business Owners
Changes to Pass-through Tax Deductions Begin in 2018
If you have a small business, you probably have a pass-through business. A pass-through business pays no tax itself, but the business owners pay the business tax through their personal tax return each year.
The Tax Cuts and Jobs Act of 2017 includes some tax changes that may benefit pass-through businesses that you should know about. These potential benefits will take effect for 2018 taxes (for returns filed in 2019). The most important possible benefit is a pass-through tax deduction of 20 percent on net business income. Read more about this in this article about the benefits and drawbacks of the Trump Tax Cuts Plan.
Is My Business a Pass-through Business?
Pass-through tax treatment means that the taxes of a business are "passed through" to the tax return of the individuals owning the business.
Pass-through businesses include:
Two types of businesses are not pass-through businesses: corporations and LLC's electing to be taxed as corporations. Taxes for corporations aren't pass through because corporations are separate entities from their owners. Pass-through status also means that these business entities are not subject to double taxation, as are corporations.
If a business owns another business, the tax for the owning business passes through. For example, if a corporation owns all or part of an LLC, the tax for the LLC passes through to the corporation.
Changes to Pass-through Taxes Effective in 2018
As noted above, pass-through businesses will have a new tax situation beginning in 2018. A deduction of 20% of "qualified business income" (QBI) can be taken. Qualified business income is tied to the owner's investment in the business, either in wages paid to employees or investment in capital assets bought and used in the business. Capital assets could be a business car, equipment, or furniture. In other words, if your small business doesn't have employees, and you don't have many assets, you probably won't be able to take this deduction.
The calculation for this QBI deduction is complicated. Kelly Phillips Erb at Forbes has more details on how the calculation for this 20% deduction would work. She also points out that the deduction doesn't affect your ability to take deductions on business expenses on your business tax return.
The deduction will be phased out for service professionals (in professions like accounting, law, healthcare, and others) once their income reaches $157,500 for singles and $315,000 for joint filers. This standard deduction will end after 2025.
How Pass-Through Taxes Work
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 work in two steps for these businesses:
Step One: The business calculates its net income (gross income minus deductible expenses). The calculation may be on a tax return (for partnerships and S corporations) or on a schedule on the person's tax return (for single-person businesses).
Step Two: The business owner includes their share of the net income of the business on their personal tax return. For a single-person business, the tax is figured on the owner's entire net income. For multiple-owner businesses, the tax is divided among the owners.
Pass-through Taxes for Sole Proprietorships and Single-Member LLCs
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 (the net income) of the business is passed through to the owner's personal tax return in a different way for each.
For partners in a partnership, 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 (owners) 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
Self-employment taxes (Social Security and Medicare tax for self-employed individuals) also pass through to business owners. 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. As with pass-through income tax, self-employment tax is not paid by the business, but by the individual, since it relates to the individual's Social Security and Medicare benefits.
Disclaimer: This article includes a general discussion of pass-through taxes, and it's not intended to be tax or legal advice. Every business tax situation is unique; before you prepare your business taxes, discuss your tax situation with a tax professional.