What is pass-through taxation

One common term of art that business owners need to understand is "Pass-Through taxation". This is a simplified explanation of how it works and how it attributes the income of a business entity like an LLC, to the owner directly. 

Pass-through taxation is a business structure where the company does not pay corporate income taxes itself. Instead, profits and losses "pass through" directly to the owners' personal tax returns, where they are taxed just once at individual income tax rates. 

How It Works

• No Entity-Level Tax: The business doesn't send a corporate tax return or payment to the IRS. It files an information return, but the income itself is treated as personal income for the owners. 
• Avoids Double Taxation: Traditional C-corporations suffer "double taxation"—the corporation is taxed on its profits, and owners are taxed again on any dividends. Pass-throughs bypass this, ensuring profits are taxed only once. 
• Passes All Items: Along with profits, business losses, credits, and deductions also pass through, which can lower an owner's personal tax liability. 

Common Entity Types

The vast majority of US businesses use this structure. It includes: 

• Sole Proprietorships: Income is reported directly on the owner's personal Form 1040.
• Partnerships & LLCs: Income passes to partners or members based on their share of the profits.
• S-Corporations: Corporate income passes through to shareholders to be taxed at their individual rates.

Key Benefits & Considerations

• Qualified Business Income (QBI) Deduction: Under tax code provisions, many pass-through owners can deduct up to 20% of their qualified business income. 
• Self-Employment Tax: Owners of pass-through businesses (especially sole proprietors) must typically pay self-employment taxes to cover Social Security and Medicare. 
• Undistributed Profit Tax: Owners owe taxes on all net profits, even if that money was left in the business's bank account to fund growth rather than distributed to the owner. 
• Pass-Through Entity Tax (PTET): More than 30 states have enacted a PTET, which allows the business to pay state taxes directly, creating an offsetting tax credit that helps owners bypass individual federal limits on State and Local Tax (SALT) deductions. 

Resources for Further Guidance

• Tax Policy Center Guide: A detailed breakdown of the different types of pass-through businesses.
• Cornell Law School Lexicon: Legal definitions and rules surrounding pass-through taxation entities. 

THIS IS NOT TAX ADVICE

Nothing in a general informational forum like this is ever specific tax or legal advice. Always get advice from a qualified professional like a CPA or attorney, based on your specific facts.

Asset protection attorney Ike Devji has over two decades of experience devoted to asset protection planning for high net worth business owners, physicians and real estate investors across the United States. Millionaire EDU is part of a continuing series with legal and financial info that successful people need to know but have often never been taught.