What does Pass-Through Taxation mean, what are the benefits, and does it apply to my LLC or INC?
Pass-through taxation allows the business owners or members to report any profit or loss on personal tax forms.
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Limited Liability Protection
Can Issue Stock
Tax implications are a major consideration when forming a new business entity.
By default, Sole Proprietorships and single-member LLCs are treated as pass-through tax entities unless elected otherwise with the IRS.
Any income is reported via the Schedule C attachment on the owner’s personal tax return filing. This also means that the tax filing deadline is April 15th every year, just like for personal taxes.
Similarly, pass-through taxation reduces the amount of record keeping and reporting necessary to stay in good standing with the Secretary of State.
It’s simply a lower maintenance option for small businesses.
choosing the right corporate tax structure
C-Corps & Some Others Aren't Eligible
C-Corps are not eligible as they are considered wholly seperate entities from the owners, and as such any income is taxed at the corporate income tax rate.
In a C-Corp, owners or shareholders must classify themselves as employees and collect a salary.
If the ownership wants to collect on any of the corporation’s profits, they must first recognize the profits for taxation purposes and only then can those profits be paid out as dividends to the owners.
Those dividends will be taxed again, at the capital gains tax rate and with all the tax planning implications of adding dividend income to a personal tax return.
Similarly, LLC’s can elect to be treated as a corporation for tax purposes. That would have the same impact, eliminating pass-through status.
Pass-Through Tax for Multiple Owners
For entities with pass-through taxation and multiple owners, members, or partners the tax liability gets divided up a little differently.
You’ll use something called a Schedule K-1 on your personal tax return to identify your share of any profit or loss from the business.
Generally, the profit for the business will be calculated as a whole. Then, depending on your share, you’ll receive a K-1 with the amount you’re responsible for taxes on.
Obviously this can have unique tax planning implications, especially if each owner is in a different tax bracket – which is not uncommon.
Make sure you take all that into consideration. It’s not always beneficial to elect pass-through taxation, especially if you have additional income sources.
By no means a complete list, but here are some additional things to think about:
- C-Corps owners can have lower net tax liability.
Although C-Corps are subject to “double taxation”, once on corporate profits and again on dividends, they offer added tax planning flexibility.
- S-Corps have additional tax benefits.
Like C-Corps, S-Corps can elect owners as employees, potentially yielding additional tax benefits.
- Electing to be taxed as a corporation can solidify limited liability protection.
By separating corporate and personal income taxes, you further show the separation of personal assets from business liabilities.
Common Pass-Through Tax Questions
No, it’s not possible because C-Corps are considered entirely separate from the owners and must file a corporate tax return.
You can however elect corporate taxation for an LLC or Partnership.
Double taxation just means that the corporate profits are taxed twice on its way to the owners’ bank accounts.
Once as profit for the corporation at the corporate tax rate, and then again as a dividend at the individuals income tax rate.
This is really a question for your tax professional and business partners.
It can be, but double taxation can also be more flexible and has the potential to deliver a lower net tax liability than pass-through taxation.
If you’re a Sole Proprietor or single-member LLC, then by default you’ll be taxed on a pass-through basis. To elect corporate taxation, you will have to complete specific forms with the IRS.
Multi-member LLC’s and Partnerships will get taxed as partnerships, on a pass-through basis with each member responsible for their share of profit/loss on their personal tax forms. To elect corporate taxation, you will have to complete specific forms with the IRS.
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