A Small Business Guide to Understanding Pass-Through Taxation

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The world of Big Business is complex and confusing. Need proof? Consider a large company’s taxation. The income of corporations—businesses that are legally structured to separate their owners and their operations—is taxed at two different points.

First, the company pays its own taxes. If you look at a corporation’s income statement filed with the SEC, you’ll see a line that says something like: “income before income taxes.” Right after that, there’s a line for taxes and a line for “net income.”

This is the first time the corporation’s income is taxed. The second time is when the remaining income is paid out to investors and shareholders. When you receive a dividend (a share of the amount listed on that net income line), you’re taxed.

Some people think this corporate tax is the only fair way to fund the world, and some believe it’s the worst thing since sliced bread. Regardless, it’s the way big companies fund the government.

For small businesses, though, this isn’t the case. Welcome to the world of pass-through taxation.

pass through taxation

Pass-through taxes in a nutshell

Small businesses don’t have shareholders, they’re just headed by some guy or three people in Toledo. That means small businesses aren’t corporations; they’re s-corps, sole proprietorships, or partnerships.

Instead of taxing the income a business makes and then taxing the distribution, small business income is taxed just once: when it passes through the business to the owner(s).

This is known as pass-through taxation and it makes taxes much simpler—and historically lower—for small businesses.

This isn’t meant to be a magic formula for lower taxes. First of all: it only applies to the earnings that would be distributed in a corporate setting. The income that employees and owners make is still subject to all the usual employment taxes.

Pass-through taxation is designed to simplify the tax process for businesses that are really nothing more than one person. Jill the accountant doesn’t need to be taxed both as Jill’s Accounting Corp and Jill Anderson—she’s just Jill. Pass-through taxation reflects that one-to-one correspondence between person and business.

Who does pass-through taxation apply to?

As it turns out, almost every business is a pass-through business. According to a recent article from the Brookings Institute, 95% of American businesses are identified as pass-through for tax purposes. Most of these businesses are sole proprietorships.

That’s probably because sole proprietorships take almost no effort to establish, don’t require costly filings, and are fairly easy to manage in almost every instance. A single business owner typically chooses between a sole proprietorship or a—more expensive to set up, but legally separated—LLC.

Pass-throughs are even more uniformly small businesses. The same Brookings report cites the U.S. Treasury, reporting that 99% of all businesses in America generate less the $10 million in annual revenue. If you’re reading this and running a small business, chances are overwhelmingly in favor of your outfit being a pass-through business.

Looney_PassThrough_Figure 2

Small businesses by size. (Source: Brookings Institute)

Of course, because there are tax benefits to being a pass-through, there are some folks who aren’t the target audience but manage to squeeze themselves into the definition. If you made it economically favorable to be a sentient turnip, you can bet the American landscape would suddenly be full of them.

How does pass-through taxation affect small businesses?

If you run a small business, the main thing you need to keep an eye on is the personal tax rate. That’s where most of the taxes you pay derive, with others coming from employment taxes pending on your business’s structure.

The nice thing about the pass-through tax setup is that there’s nothing you need to do to take advantage of it. While double-taxed income from corporations can have over 50% of its original value removed in taxes—35% at the corporate level and about 16% as distributions—individual income tax brackets top out at 39.6% for income exceeding $418,400.

All you have to do to get the lower rate is not take on shareholders.

Figuring out how much you owe

Since we’re running out the clock on 2017, now is a great time to get ready for tax season. Capterra’s accounting software directory has more than 160 options that include tax management features. From large to small, there’s an accounting solution available for every business.

Now is also a great time to talk to a small business accountant. Whether or not you want to be a lightly-taxed, sentient turnip, an accountant will point you in the right direction.

2018 is a great year to file your personal return early. Post-Equifax hack, there’s been speculation that tax return fraud will see a big jump over the coming year. Don’t let someone else file your taxes for you—fraudulently—and cash out your sweet, sweet refund.

Looking for Accounting software? Check out Capterra's list of the best Accounting software solutions.

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Andrew Marder

Andrew Marder is a former Capterra analyst.

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