Pass-Through Taxes and How They Affect Business Owners
A big change came to pass-through tax deductions in 2018
Most small businesses are pass-through businesses. They pay no taxes themselves at the business level. Owners report business income and pay the business tax on their personal tax returns. These businesses include LLCs, partnerships, S corporations, and sole proprietorships.
The Tax Cuts and Jobs Act (TCJA) introduced a significant change that affects these pass-through businesses.
2018 Changes—The Pass-Through Income Deduction
The TCA's pass-through deduction took effect on Jan. 1, 2018. Sole proprietors, S corporations, LLCs, partnerships, and other pass-through businesses can now shave 20 percent off their pass-through incomes and pay tax on the remaining balance—always subject to certain rules and exceptions, of course.
Most notably, "Specified Service Trades and Businesses" (SSTBs) were ineligible to claim the deduction in the first drafts of the law. These include accounting, consulting, and law businesses, among other fields—basically any field where the owner earns her income thanks to her own skill or reputation.
That doesn't sound fair, because that covers the vast majority of partners, sole proprietors, or other businesspersons. Congress realized this, and the tweaking began.
The final version of the deduction does not exclude SSTBs unless their 2018 income is $315,000 or more for married filing jointly taxpayers in tax year 2018. The limit for all other taxpayers is $157,500. The deduction begins phasing out beyond these thresholds. In other words, that 20% deduction shrinks to 15 percent to 10 percent and so on until it disappears entirely based on how much over these limits the taxpayer earns.
SSTBs aren't barred from claiming a pass-through deduction at all until they reach incomes of $415,000 for those who are married and filing jointly, and $207,500 for all others in 2018. Everyone else can subtract the applicable percentage from their pass-through income and pay taxes on the balance.
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. 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 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:
- The business calculates its net income: gross income minus deductible expenses. This calculation might be done on a tax return for partnerships and S corporations, or on a Schedule C filed with Form 1040 for single-person businesses.
- The business owner includes her share of the net income of the business on her 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.
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 new 2018 Form 1040. The total from Schedule 1 is then entered on line 6 of the 1040.
Schedule 1 includes other types of income as well, such as capital gains, royalties, and unemployment compensation.
Single-member LLC's 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 LLC's
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 as 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.