Just Passing Through - The Basics of Pass-Through Taxation
Pass-through taxation means individuals are subject to income taxes, not the business itself. For example: a partnership doesn’t pay income taxes, the partners do. The most common forms of pass-through business types are partnerships, S-corporations and sole-proprietorships. Let's look at a couple of situations that'll help you wrap your mind around key aspects of pass-through taxation.
Taylor and Tyler are 60%/40% owners of a C-corporation , NOT a pass-through business. The business had $100,000 of taxable income last year so the business itself is expected to pay 21% federal and some state taxes; let’s assume 6% state, so the income tax rate is 27%. The IRS wants $27,000. The business pays these taxes, not Taylor and Tyler.
On the other hand, if the business was formed as a partnership – which IS a pass-through business –$60,000 of taxable income is reported on Taylor’s Form 1040 and Tyler reports $40,000. More taxable income means more taxes are due – whether or not Taylor and Tyler took any cash out of the business! And since it’s business income, it’s probably subject to hefty self-employment taxes as well. Taylor and Tyler pay these taxes, not the business -- because it's a pass-through.
Partnerships file Form 1065 while S-Corporations file Form 1120-S. These forms create Form K-1s, one for each partner or owner, that pass through the taxable activity of a business to the individuals. Sole-proprietors typically report their business activities by attaching a Schedule C to their Form 1040. There’s a lot more to it than can fit in a blog post, but we’ll simply end with a cautionary tale tax accountants see far too often:
Tyler didn’t see it coming. A K-1 with $40,000 of taxable income resulted in a $14,000 unexpected tax bill. What’s worse, the partnership is now cash-poor so getting a distribution at this point is unworkable. $14,000 of taxes are due and Tyler doesn’t have the money. It's bad. And it’s no consolation that Tyler now fully understands the impact of pass-through taxation.
The moral: don’t be Tyler. Good planning could have prevented Tyler’s unfortunate April 15-surprise. Consult with appropriate trusted tax and legal advisors so you fully understand the impact of key business decisions before you make them.
Please know this blog post contains no tax, accounting, nor legal advice. Our posts are intended to be informative and useful for business owners. And we want you to know we are offering high-quality bookkeeping and certain tax services -- let us know if we can help.