With pass-through taxation, the taxes of a business are not paid at the entity level, but instead they are “passed through” to the individuals owning the business and appear on the individuals’ personal tax returns. There can be a number of advantages to this method of taxation for small businesses
When is Pass-Through Taxation Used?
Not all business entities qualify for pass-through taxation. A common type of business entity that utilizes this type of taxation method is a partnership. Through pass-through taxation, partners pay their portion of the overall tax burden of the partnership, and the partnership itself isn’t taxed directly. This means that the partners receive profit payments, wages and income through the profit earnings of the partnership. The partners each then pay the taxes on their portion of the profits, or if the partnership experienced a loss, they can deduct their portion of the loss. This is done by means of each individual’s personal tax return. This type of taxation also applies to other types of business entities as well, such as sole proprietorships, S corporations, and most limited liability companies (LLCs). However, LLCs can opt instead to use the type of double taxation that applies to corporations.
The Advantages of Pass-Through Taxation
There are advantages to pass-through taxation, especially as it affects smaller businesses that are structured as a partnership. Taxes are generally less complicated and easier to handle and file. It also often results in a lower tax burden, as compared to double taxation. Because of this, LLCs often opt for pass-through taxation, although they could also elect to be subject to the same double taxation that corporations are.
Double taxation occurs for corporations when they are taxed at different levels. After being initially taxed at the corporation level, the profits are taxed again at the personal level as a result of profits being distributed. Small business owners can benefit greatly from pass-through taxation, and small business owners often end up paying much less taxes than they would have if they had been required to pay the taxes twice at the federal and state levels. Because of this, sometimes it can be advantageous for small corporations to convert to an LLC, if they are currently a corporation. However, even considering the tax advantages of converting to an LLC, sometimes corporations choose not to convert, because of other reasons, such as limits on being able to go public, or to prevent managing members from being subjected to self-employment taxes.
Requirements of Pass-Through Taxation
Just because the partnership doesn’t have a tax burden, that doesn’t mean that it’s not required to file a tax return. The tax return filed by the partnership must show the finances of the partnership over the past year, and must indicate the total amount of profit or loss for the partnership itself. The tax return for the partnership also is required to indicate the profits and losses attributed to the individual partners, and if any profits were paid, the tax return must show when the profits were paid, who they were paid to, and the amount of the profits.