Pass-Through Taxes and How They Affect Business Owners

New Tax Deduction for Pass-Through Businesses

Pass-through Businesses and Taxes
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Most small businesses are pass-through businesses. The business doesn't pay its federal income taxes. Instead, the owners report business income and pay the business tax on their personal tax returns. These businesses include LLCs, partnerships, S corporations, and sole proprietorships.

Many businesses are pass-through (sometimes called "flow-through"). Pass-through businesses make up over 50% of total business income, through 2015 in the U.S.

Is Your Business a Pass-Through Business? 

Pass-through tax treatment means that the taxes of a business are literally "passed through" to the tax returns of the individuals who own the business. The tax deduction isn't taken by the business, but it's taken by the individual taxpayer(s) who own the business.

These business entities are not subject to double taxation—once as the business earns income and again at the owners' level—as are corporations.

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. If an LLC (normally a pass-through entity) elects to be taxed as a corporation, it pays corporate income taxes.

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 to the corporation.

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 can 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: 

  1. The business calculates its net income: gross income minus deductible expenses. This calculation might be done on a business-specific tax return for partnerships and S corporations, or on a Schedule C filed with Form 1040 for single-person businesses. 
  2. 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. 

New Tax Deduction for Pass-Through Businesses

The Tax Cuts and Jobs Act (TCJA) introduced a significant change that affects pass-through businesses, by adding a Qualified Business Income (QB!) tax deduction.

Sole proprietors, S corporations, LLCs, partnerships, and other pass-through businesses can now shave 20% off their pass-through income and pay tax on the remaining balance—always subject to certain rules and exceptions, of course.

The QBI deduction doesn't affect your business tax deductions. Your total taxable income from all sources for the year determines your eligibility for this deduction; if it's over a certain amount, this deduction may be limited or not available.

Who Can – and Can't – Take the QBI Deduction

The amount of the QBI deduction is calculated for the individual owner on certain types of taxable business income, including the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to a qualified retirement plan.

You can't take the QBI deduction on:

  • Capital gains or losses
  • Income as an employee
  • Certain dividends and payments in lieu of dividends
  • And other types of non-business income.

Certain kinds of service businesses aren't eligible for the QBI deduction if their income is over a specific amount. These are called "Specified Service Trades and Businesses" (SSTBs), including accounting, consulting, and law businesses, among other fields—basically any field where the owner earns her income thanks to their own skill or reputation.

A business defined as an SSTB isn't eligible for the QBI If the taxable income of these businesses is $315,000 or more for married filing jointly taxpayers and it's $157,500 for other taxpayers The deduction begins phasing out beyond these thresholds for upcoming years. In other words, that 20% deduction shrinks until it disappears entirely based on how much over these limits the taxpayer earns.

SSTBs can claim the pass-through deduction until they reach incomes of $415,000 for those who are married and filing jointly and $207,500 for all others. Everyone else can subtract the applicable percentage from their pass-through income and pay taxes on the balance.

Pass-Through Taxes for Different Types of Businesses

Sole Proprietorships and Single-Member LLCs

The business and the business owner are not separate entities from a tax standpoint in a sole proprietor business. 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 Schedule 1 of the owner's Form 1040 or 1040-SR. The total from Schedule 1 is then entered on line 6 of Form 1040.

Schedule 1 includes other types of income as well, such as capital gains, royalties, and unemployment compensation.

Single-member LLCs pay income tax in the same way sole proprietorships do, so income tax is passed through to them in the same way. 

Partnerships, S Corporations, and LLCs

In other types of businesses that are not corporations, the tax liability or 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 or profit of the partnership as a whole is calculated. This income or loss is then divided among the partners according to their distributive share set in the partnership agreement. Each individual partner receives a Schedule K-1 showing their share of the profit, which is then included on the partner's Form 1040. 

Owners of multiple-member LLCs are taxed as partners, so they 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 are Social Security and Medicare tax for self-employed individuals. They also pass through to business owners.

The amount of self-employment tax is calculated based on the business owner's net income, and it's 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. 

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. Discuss your tax situation with a tax professional before you prepare your business taxes.