Pass Through Business Taxation: What Is It And Why Should You Care?

Pass through taxation is a word that is referenced often when people are deciding what kind of business entity they should form. Although taxation is a big issue in business formation that can affect you and your bottom line for many years, many people give little or no thought to this term.

What is Pass Through Taxation?

Normally, you would think that a business pays its taxes to the IRS, and the business owners pay their taxes to the IRS. Both use their deductions, calculate their profits, and get their taxes from their profits or incomes.

But in a pass through tax entity, the business doesn’t actually send any taxes to the IRS, at least, not directly. Rather, the business’ profit becomes the profit of the business owner, and the business owner pays those taxes, along with their own taxes, together to the IRS.

This is how many business entities, including S corporations, partnerships, or sole proprietorships will pay taxes. Additionally, some LLCs get pass through taxation.

By one estimate, about 75% of all businesses that use pass through taxation, are sole proprietorships.

Why Would You Want This?

But wait—why would you want pass through taxation? What’s the benefit of having what the business makes in profit to be considered your personal profit? Doesn’t that increase your own taxes?

One big benefit is that the business’ profit will be taxed at your individual tax rate, and not corporate tax rates. Of course, this could result in you paying more or less taxes—that’s something to discuss with an accountant—but having the option to lower corporate taxes by paying your individual tax rate could be a big help to you or your business.

Additionally, some of the businesses that qualify for pass through taxation get 20% off and tax will only be assessed at the remaining profit.

Once the company’s taxes are passed through to you, the owner, you can get the 20% discount–although that reduction doesn’t apply to certain kinds of businesses, such as service-related professional businesses, if those businesses make more than $157,500 or $315,000 (depending on whether the taxpayer files joint married taxes or not).

Different Rules for Different Corporate Entities

There are even differences in pass through taxation rules, amongst the businesses that qualify for pass through taxation. For example in a partnership, the entire profit of the partnership is used as a starting point to calculate taxes. It is then divided amongst the partners according to the distributive share of each partner–another important reason to know what your partnership agreement says. The sale rule applies to multi member LLCs. But profit would not be divided in a sole proprietorship.

As a general rule, sole proprietorships and single member LLCs are treated the same way in the eyes of the IRS (though there are other legal pros and cons to each kind of entity that do differ between them).

Are you forming a business? Call the West Palm Beach business litigation attorneys at Pike & Lustig today.