What Is Pass through income?
Pass through income refers to a business's earnings that are directly "passed through" to its owners or investors for tax purposes, without being taxed at the entity level. This tax treatment is a core concept within Taxation and Business entities, applying to specific organizational structures like Sole proprietorships, Partnerships, S corporations, and most Limited Liability Companies. Instead of the business paying corporate tax on its profits, the income is reported on the owners' personal tax returns, where it is taxed at their individual income tax rates. This mechanism avoids the situation where business income is taxed first at the corporate level and then again when distributed to owners.
History and Origin
The concept of pass-through taxation has deep roots in the evolution of U.S. tax law. Historically, most businesses were either sole proprietorships or partnerships, where income was naturally taxed at the owner's individual level. The rise of the modern corporation introduced the notion of the business entity as a separate taxable person. However, a significant shift toward formalized pass-through entities gained momentum after the Tax Reform Act of 1986. This landmark legislation substantially lowered individual income tax rates relative to the top corporate tax rates, making it more attractive for businesses to structure themselves as pass-through entities8.
Furthermore, the introduction of Limited Liability Company (LLC) statutes by states, starting with Wyoming in 1977 and spreading nationwide by 1997, provided a flexible business structure that combined limited liability protection with pass-through tax treatment. Subsequent "check-the-box" regulations from the Internal Revenue Service (IRS) in 1997 further simplified the election of tax status for unincorporated entities, allowing them to choose taxation as a partnership or corporation, thereby accelerating the proliferation of pass-through businesses. By 2015, pass-through businesses accounted for 95% of all U.S. businesses and 63% of all business income, a significant increase from 83% of businesses and 25% of business income in 19807.
Key Takeaways
- Pass through income is taxed only once, at the owner's individual income tax rate, avoiding the corporate-level tax.
- Common pass-through entities include sole proprietorships, partnerships, S corporations, and most LLCs.
- Owners report their share of business profits or losses on their personal tax returns.
- The growth of pass-through entities was significantly influenced by tax law changes, such as the Tax Reform Act of 1986 and the introduction of LLCs.
- Pass-through status simplifies tax filing for many small and medium-sized businesses by integrating business income directly into individual tax returns.
Interpreting Pass through income
Interpreting pass through income primarily involves understanding that the business itself does not remit federal income tax on its Profits. Instead, the tax burden falls directly on the individual owners, partners, or shareholders. This means that an owner's personal Individual income tax rate, rather than a separate corporate rate, determines the taxation of the business's earnings. For example, if a partnership earns $100,000 in net income, and there are two equal partners, each partner will report $50,000 of that income on their personal tax return. This amount is typically treated as Ordinary income, though certain components, like Capital gains, maintain their character as they pass through to the owner's tax return6. Understanding this distinction is crucial for business owners and investors, as it directly impacts their personal tax liability and overall financial planning.
Hypothetical Example
Consider Jane, a software engineer who decides to start her own consulting firm as a Limited Liability Company (LLC) and elects to be taxed as a sole proprietorship. In her first year, her LLC generates $120,000 in revenue. After deducting legitimate Operating expenses, such as office rent, software subscriptions, and marketing, her business has a net profit of $80,000.
Because Jane's LLC is a pass-through entity, the $80,000 profit is not taxed at the business level. Instead, this entire amount "passes through" to Jane. She reports this $80,000 as business income on her personal Form 1040, Schedule C. This income is then combined with any other personal income she might have (though in this example, it's her primary source of income) and taxed at her individual income tax rate. Jane is also responsible for self-employment taxes (Social Security and Medicare) on this net profit. Even if she reinvests a portion of the $80,000 back into the business, she still owes tax on the full amount of the pass through income in the year it was earned.
Practical Applications
Pass through income taxation is fundamental to several business and investment strategies. It is the default tax treatment for the vast majority of small and medium-sized businesses in the United States, including local shops, professional service firms, and many startups. For instance, a law firm structured as a partnership or an independent contractor operating as a sole proprietorship will have their business income treated as pass through income.
The simplicity of single-level taxation makes these structures attractive for entrepreneurs seeking to minimize compliance burdens associated with separate Corporate tax filings and dividend distributions. It also allows owners to directly apply business losses against their personal income, which can be advantageous in the early, unprofitable stages of a venture. The Internal Revenue Service (IRS) provides detailed guidance on pass-through entities and their tax obligations in publications like IRS Publication 334, "Tax Guide for Small Business"5. Moreover, recent tax legislation, such as the Tax Cuts and Jobs Act of 2017 (TCJA), introduced provisions like the Qualified Business Income (QBI) deduction (Section 199A), which allows eligible owners of pass-through entities to deduct up to 20% of their qualified business income, further reducing their effective tax rates4.
Limitations and Criticisms
Despite its advantages, pass through income structures and related tax provisions face certain limitations and criticisms. One significant drawback for business owners is that profits are taxed in the year they are earned, even if they are not distributed to the owners but rather Retained earnings and reinvested in the business. This can create a cash flow challenge, as owners might owe taxes on income they haven't yet received.
Furthermore, critics argue that the tax benefits associated with pass-through income, particularly deductions like the QBI deduction, disproportionately favor high-income earners and contribute to income inequality. Research has indicated that a significant portion of these tax benefits accrue to the wealthiest households, with little evidence of a discernible trickle-down economic benefit in terms of increased investment or job creation3. This has led to concerns about tax avoidance opportunities and the integrity of the overall income tax system, as wealthy taxpayers may reclassify income to qualify for lower rates intended for pass-throughs2. The complexity of these rules can also lead to unintended consequences and challenges in ensuring horizontal equity, where businesses with similar incomes might face different tax burdens1. Owners of pass-through entities may also be subject to self-employment taxes in addition to regular income taxes, covering Social Security and Medicare contributions.
Pass through income vs. Double Taxation
The primary distinction between pass through income and Double taxation lies in the number of times business profits are taxed before reaching the owners. With pass-through income, a business entity (like a partnership or S corporation) is not taxed on its profits at the corporate level. Instead, the income "passes through" directly to the owners' personal tax returns, where it is taxed only once at their individual rates. This single layer of taxation is the hallmark of pass-through entities.
In contrast, double taxation typically applies to traditional C corporations. Here, the corporation first pays Corporate tax on its net income. Then, when the remaining after-tax profits are distributed to shareholders as Dividends, those dividends are taxed again at the individual shareholder level. This results in the same income being taxed twice: once at the corporate entity level and again at the individual shareholder level. The avoidance of this dual tax burden is a key reason many businesses opt for pass-through structures.
FAQs
What types of businesses are pass-through entities?
Common pass-through entities include sole proprietorships, partnerships, S corporations, and most limited liability companies (LLCs). These Business entities are designed to avoid separate corporate-level taxation.
How is pass through income reported on my tax return?
If you are an owner of a pass-through entity, your share of the business's Profits or losses is reported on your personal income tax return (Form 1040). For sole proprietorships, this is typically on Schedule C. For partnerships and S corporations, you'll receive a Schedule K-1 detailing your share of income, which you then report on Schedule E.
Do I pay self-employment tax on pass through income?
Generally, yes. Owners of pass-through entities like sole proprietorships and partners in a partnership are usually subject to self-employment taxes (Social Security and Medicare) on their share of the business's net earnings. However, shareholders of S corporations may have different rules regarding self-employment tax on their distributions, depending on if they are considered to be receiving a reasonable salary. Tax deductions related to self-employment taxes may also apply.