Pass-Through Taxation Definition

What is pass-through taxation?

The simple definition of pass-through taxation (or flow-through taxation) is that it’s a tax treatment that allows all income, losses, credits, and deductions of a business to pass through to the owner or owners. When the business makes a profit, the entity itself doesn’t pay tax on its income. Instead, it passes the income through to the business owners, who pay income tax on the profits. The owners report the income on their personal tax returns and calculate their taxes according to their personal income tax rate. 

In contrast, double taxation is another type of tax treatment that taxes the same income twice. If a C corporation generates income, that legal entity pays income tax on its earnings at both the corporate level and the individual level. First, the corporation pays taxes on its corporate income. Then, it passes dividends down to the shareholders, who pay tax again on their individual tax returns. 

What are the different types of pass-through taxation entities?

For sole proprietorships, partnerships, limited liability companies (LLCs), and S-corporations, pass-through taxation is the default tax treatment. These business types are known as “pass-through entities.” 

Corporations and LLCs that elect to be taxed as C-corporations aren’t pass-through entities. They’re subject to double taxation. 

Pass-Through Taxation Advantages

One of the main pass-through taxation benefits is that the entity itself doesn’t pay income tax. Business profits are only taxed once at the owner’s personal tax rate. Compare this to double taxation, where the corporation pays taxes at the corporate rate and shareholders pay taxes again at their individual rate. This can significantly impact the amount of money you have leftover to reinvest back into the company. 

Business owners also like the ease of formation, compliance, and tax filing that comes with running a pass-through entity. 

Pass-Through Taxation Disadvantages

We mentioned that pass-through taxation might not be for everyone, so let’s look at the reasons for this. First, reporting business profits on your personal return could put you into a higher tax bracket. You may actually end up paying more taxes than if your business was subject to double taxation. 

Another potential disadvantage of a pass-through entity is that it may be difficult to attract investors. Often, investors like corporations because they have stricter requirements. 

Summary

With pass-through taxation, your business doesn’t pay income taxes on its profits. Instead, the owners report the company’s income on their personal tax returns. They can also include all business credits, losses, and deductions on their return.