How Small Businesses Can Master Pass-Through Taxation
- October 13, 2019
- Posted by: BenG-Admin
- Category: Business, IRS, Taxes, Wage
Today, small businesses can capitalize on a variety of options to organize and structure
business activities for tax reasons. The IRS can view small business owners as sole proprietors
and without incorporated status.
Conversely, C corporations are separate entities in which owners are taxed twice for the sake of
distribution of dividends. The term “pass-through” entity applies to partnerships, S corporations,
and limited liability companies (LLCs).
It’s not a secret that pass-through businesses have reformed the American economy through
dominant business practices. As per the amended version of the Tax Cuts and Jobs Act, small
businesses can avail pass-through tax deduction of up to 20%. The percentile is coded as per
instructions of the Internal Revenue Code (IRC) Section 199A.
In this article, you will learn about requirements to qualify as a pass-through entity and how
small businesses can make the most out of pass-through taxes:
The Exact Nature of Pass-through Taxes
The first thing small businesses should remember is that pass-through entities are not liable to
pay corporate income tax. Instead, business owners can report individual tax returns. Apart from
C Corporation, other business structures can benefit from pass-through taxes as well.
Unlike C corporations, small businesses have the luxury to employ a handful of individuals at a
low-cost physical infrastructure to get the same benefits as major companies can get.
Technically, the process of pass-through taxation refers to when the income of small businesses
is taxed as a singular event.
Since pass-through entities don't have to fret about paying taxes as C Corporation, it allows
small businesses the freedom to report income taxes to the IRS just once. And after the
distribution of income among owners, you can file and pay your personal tax returns.
In hindsight, small business owners share the affinity towards pass-through taxes largely
✓ It provides higher legal protection and helps you avail of further business opportunities.
✓ It allows you to calculate your annual taxable income just once.
Now, don’t perceive pass-through taxes as a magic lantern that will automatically decrease your
annual taxes. Instead, think of it as a self-sustaining mechanism that distributes your earnings in
the semblance of a corporate setting. However, small business owners still have to pay
Primarily, a pass-through tax simplifies the tax process and facilitates small businesses that
revolve around a limited number of employees. In simple terms, pass-through taxation
encompasses reflective measurement and division of business and person who runs it.
The Applicability of Pass-through Taxes for Small Businesses
Small business owners are required to pay income tax on entire business earnings of the year.
However, a limited liability company doesn’t have to distribute the cash from the company’s total
earnings to pay the remaining taxes.
❖ What does 20% Deduction Entail?
The 20% deduction may have started last year, but now its end-result is available and praised
by sole-proprietorships, partnerships, and limited liability companies. Though there are certain
limitations involved for sole-proprietors, the tax-break couldn’t be perfect for small businesses.
❖ Personal Tax Rates
So long as your business is organized around pass-through entities, changes in individual tax
rates won’t have a lasting impact on the overall paid business taxes. However, this generalized
notion essentially depends on the size of your business.
❖ The Ideal Business Entity
Contemporarily, the formation of S corporation is probably the ideal business structure for most.
Furthermore, the growth opportunities for LLCs have quickly surpassed every industry's
expectations. For instance, there are more than a million LLC entities than they were just two
decades ago in the U.S.
The Growth and Popularity of Pass-through Entities
In a way, you can presume that the majority of the businesses fall under pass-through taxation
rules. In fact, more than 90% of American businesses meet the eligibility criterion to be a pass-
through entity for tax purposes. However, a large chunk of such businesses is sole-
proprietorships. And why wouldn’t they? Sole-proprietorship takes minimal effort to establish
and become a new standard to start a business.
Moreover, the uniformity of pass-through entities is another reason for its popularity among
entrepreneurs and business owners. Therefore, if you are running a small business, there’s a
good chance it falls under the umbrella of a pass-through entity – which means you can avail all
the pass-through taxation.
Implementation of Pass-through Taxes
From a taxation point-of-view, business and business owner of sole-proprietorship are not
considered separate entities. It makes sense because your business tax filing ultimately
becomes a part of the entire personal tax return. Therefore, Schedule C is used to calculate
total profits or losses that are passed on to Form 1040. Similarly, Schedule 1 is used to note net
income that is passed on the same 1040 Form.
Also, Schedule 1 can include your total capital gains, royalties, and current unemployment
compensation, along with different types of income. You may also want to undertake single-
member LLCs that function in the same capacity as the sole-proprietorships.
Ultimately, your primal focus of interest should be on the personal tax rate. That’s because the
majority of the paid taxes are inherently derived from unpaid employment taxes, and so on. So
long as you operate as a pass-through business entity, a local tax specialist can help you take
advantage of most of the benefits.
What’s even more interesting is that S corporations get the opportunity to reduce 50% of the
taxes from the total value. Comparatively, even C corporations don’t enjoy the same
distributional tax benefit. The trick is to lower your tax rate. And the lower the rate, the more
wiggle room you’ll have to decrease the total income tax figure.
Pass-through Taxes for Partnerships and LLCs