A pass-through deduction is a tax break given to business owners. This deduction lowers the owner’s tax base. Here we explore this topic in detail.
Overview of Pass-Through Taxation
Pass-through taxation is when the income taxes of a business are “passed through” to the owners of that business. The business as an entity is not taxed, but the owners of the business report the income and deductions on their personal taxes. The alternative to pass-through taxation is double taxation, which traditional corporations and C-Corporations face. Double-taxation occurs because the corporation is taxed at the entity level, and distributions to shareholders are taxed at the shareholder’s personal level.
The types of pass-through entities are:
- Sole proprietorships and single-member LLCs
- Business profits and losses are calculated on Schedule C of the owner’s 1040 (personal tax return) and the net income/loss is passed through to Schedule 1 of the small business owner’s 1040, which then gets entered on line 6 of the 1040.
- Partnerships and multiple-member Limited Liability Companies
- The net income/loss of the whole partnership is calculated and divided among the partners depending on their share. Each partner receives a Schedule K-1 which shows their share of the net income/loss, and this total is entered on the 1040.
- S-Corporations
- Taxed the same way as partnerships and multiple-member LLCs
It’s important to note that the above business entity types are also responsible for paying self-employment tax, which includes Social Security and Medicare tax. The amount of self-employment tax is based on the business’s net income and is reported on the owner’s 1040.
The business structure types not included above, traditional corporations and C-Corporations, are not pass-through entities and are subject to double-taxation.
Benefits of Pass-Through Taxation
The major benefit of pass-through taxation started in 2018 with the Tax Cuts and Jobs Act, Section 199A. This provision allows for pass-through business owners (sole proprietorships, partnerships, S-Corporations, and some trusts and estates) to deduct up to 20% of their qualified business income (QBI). [1] There are several qualifications and phase-outs which make it complicated, but in general, taxable income must be less than $213,300 for a single taxpayer and $426,600 for joint taxpayers, and there are phase-outs for each type of taxpayer. There are also limitations on certain types of businesses that can have QBI, and the limitations are for companies where the owner’s reputation is the principal asset.[2]
There is a component in addition to QBI for REIT (real estate investment trust) dividends and PTP (publicly traded partnership) income. A REIT is a company that owns, operates or finances income-producing properties.[3] A PTP is a type of limited partnership where the partners’ shares can be freely traded on a securities exchange, but 90% of the partnership’s gross income must come from qualifying sources as defined by the Internal Revenue Service.[4] Since this is outside the scope of this article, you can check out more information about the REIT/PTP income deduction here: https://www.journalofaccountancy.com/news/2020/jun/sec-199a-deduction-for-reit-dividends.html
Let’s get back to how the 20% Qualified Business Income deduction is calculated. QBI is the net of income, gains, deductions, and losses from a qualified trade or business. Excluded items are capital gains/losses, certain dividends, interest income, W-2 income and/or reasonable compensation from an S-corporation, and guaranteed payments from a partnership. The tax deduction is the lesser of:
- 20% of QBI plus 20% of REIT dividends/PTP income, or
- 20% of taxable income minus net capital gain[5]
The source listed for footnote 5 contains 59 questions and answers about this tax deduction and requirements as it applies to different situations, so I highly recommend reading through them. Besides the QBI deduction, the other major benefit of pass-through taxation is, of course, avoiding double-taxation.
Disadvantages of Pass-Through Taxation
The biggest disadvantage of pass through income is that the owner(s) of a pass-through entity is required to report all of the net income on their personal tax returns, even if they don’t receive all of that net income as distributions.
How Are Losses Handled with Pass-Through Taxation?
What happens if your pass-through business has a loss? This situation is particularly prevalent in 2020 because of COVID-19 causing many small businesses to pause operations. The IRS stepped in and amended the previous loss limitations with The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) which repealed the “limitation on excess business losses of noncorporate taxpayers to tax years beginning after 2020 and before 2026.” You can also amend your 2018 and 2019 returns if you used the previous limitation in those years.[6] Excess business losses mean taking losses more than $250,000 for a single taxpayer or $500,000 for a joint taxpayer.
To put it simply, the CARES Act makes pass-through business owners able to use their net loss to offset 100% of their net income during 2018-2020. If you had a loss in any or all of those years, you do not have to pay any taxes on the business for those years.
When Does it Make Sense to be Taxed as a C-Corporation?
It makes sense to be taxed as a C-corporation if the company is not going to be making distributions to shareholders, meaning all of the income is going to be put back into the business. The entity will still have taxable income at the entity-level, but not at the shareholder level.
Another situation where it makes sense to be taxed as a C-Corporation is to take advantage of the 21% flat corporate tax rate, which is lower than the maximum personal tax rate of 37%.[7] The lower corporate income tax rate could be beneficial if most or all of the owners of a business have a higher tax bracket.
Additionally, health insurance, stock options, company vehicles are tax-deductible for C-corps and tax-free to the employees receiving them.
Conclusion
By using pass-through taxation, the IRS makes it simple for business owners to combine their personal and business taxes. For most small businesses, especially start-ups, the benefits of pass-through taxation definitely outweigh the costs because of the deductions allowed. Hopefully, you gained some insight into how pass-through taxation works for your business, especially during this challenging time for business owners.
[3] https://www.investopedia.com/terms/r/reit.asp
[4] https://www.investopedia.com/terms/p/ptp.asp
