Pass-Through Taxation: Everything You Need to Know

The pass-through taxation method is used with limited liability corporations, sole proprietorships, and partnerships. This is where business owners are required to pay taxes on any and all profits of activity that their individual tax returns yield. The income the companies returns "passes through" the business to the business owner's tax return. On the contrary, a corporation or business who chooses to have a corporate-style taxation will be directly taxed on any and all business profits.

The income of pass-through businesses will have a marginal tax rate that can go past 50 percent in certain states. These businesses will only have a layer of tax off their profits, as compared to C corporations who have double taxation. Since 1980, the number of C corporations has decreased, while the amount of pass-through businesses has steadily risen, nearly tripling. There are several advantages to pass-through companies. They have a higher net business income than most C corporations do. They also employ almost half of the private sector workforce.

Pass-through businesses tend to be smaller than C corporations, but that doesn't mean they're all small businesses. A large portion of pass-through business income is taxed at the tax rates for top individuals. The individual tax code needs to be addressed with tax reform having the goal of increasing the competitiveness of businesses in the United States. One of the main objectives of tax reform is to grow the economy and increase the competitiveness of businesses in the United States. One way to do this is by decreasing taxes on investment and saving through business tax reform.

Hours upon hours are spent dedicated to increasing the corporate part of the tax code. However, a large portion of the business activity is missed by corporate-only business tax reforms. S corporations, sole proprietorships, and partnerships are the main part of businesses as well as over 60 percent of American's net business income. Pass-through businesses are a large part of the economy in the United States, so it's essential that the tax reform addresses the personal income tax code as well as the tax code that is corporate.

An advantage of a pass-through entity  is the effects of double taxation are reduced through this special business structure. They don't pay income taxes as other businesses do at a corporate level. There are several different pass-through businesses. A sole proprietorship is when an individual owns it and is an unincorporated business who reports their income on Schedule C portion of the 1040 tax form. A partnership has multiple owners that own an unincorporated business. The owners can be individuals or other companies.

A limited liability corporation, or LLC, is a company that has limited liability similar to a regular C corporation. An S corporation can be owned solely by citizens of the United States and not by other partnerships or corporations. It's a domestic corporation that can have a maximum of 100 shareholders. Shareholders or owners of pass-through businesses pay a tax on the income when they get a dividend or sell a stock and get a capital gain. Another factor that's different between traditional C corporations and pass-through businesses is the later pay whole tax on their business's income each year as the business makes it.

What Are the Different Taxes That Pass-Through Businesses Pay?

Losses and income are reported to their owners in pass-through businesses. Therefore, these businesses will have the same marginal tax rates that individuals do. The rates begin at 10 percent for the first $9,075 of taxable income (or $18,150 if married and filed jointly) and increase to 39.6 percent on any income that's taxable over $406,750 (or $457,601 if married and filed jointly). Partnerships and sole proprietorships will pay the tax for self-employment. These taxes are based on self-employment income to fund Medicare and Social Security. They are equal to what those who earn a wage pay in their payroll taxes.

The self-employment payroll tax gets combined with 15.3 percent on the first $117,000, 2.9 percent on the following $83,000, and 3.8 percent on income over $200,000 (or $250,000 for filing jointly). The owners of partnerships and sole proprietorships will be subject to the self-employment payroll tax on the majority of their net business income. Owners of S corporations will need to pay self-employment taxes on a percentage of their net income that's paid out. S corporation owners can decide if their income is wages or a profit distribution. If designated as wages, it will be subject to self-employment tax, while non-wage income will not.

Owners of S corporations whose income is earned by a shareholder that's passive in a corporation that the owners don't participate in the daily activity but still gets an income will not be subject to the self-employment payroll tax. The tax will apply to investment incomes when a taxpayer's modified AGI goes above $200,000 (or $250,000 for filing jointly). Pass-through business income may be subject to the Alternative Minimum Tax, or AMT. This makes the tax rate that business owners pay higher.

Pass-through businesses will also pay local and state income taxes. This can vary anywhere from zero percent in states that don't have personal income taxes to thirteen percent, which is California's highest top marginal income tax rate. Top marginal tax rates that Californian sole proprietors will face max out at are 51.9 percent. The top marginal income tax rate for active S corporation shareholders will be lower, as they don't pay the tax on payroll for non-wage income that's for business. The median marginal income tax rate in the United States on partnerships and sole proprietorships is 47.2 percent and 44.5 percent for active S corporation shareholders.

Traditional C Corporations Tax Differences

There are different tax treatments of C corporations and pass-through businesses, so the two businesses will face a differential tax burden. C corporations will be taxed first at the entity level, which is 39.1 percent of the combined average and federal state tax rate. When the owners or shareholders realize those profits as either capital gains or dividends, the owners will pay taxes on their income once more. Corporate income double-taxation creates a difference between the tax burden on the income from the C corporations and pass-through businesses.

Pass-through businesses having the highest marginal tax rate, when merged with the state rate, will have an estimated rate of 47.2 percent, and the tax rate was 56.5 percent on income from C corporations that are realized at the level of the shareholder.

Pass-Through Businesses That File Tax Returns Have Seen an Increase Over the Previous Thirty Years

The Tax Reform Act of 1986 decreased individual income tax rates significantly. Since then, the amount of pass-through business in the United States has grown drastically. From 1980 to 2011, the amount of tax returns for pass-through businesses tax returns grew by 175 percent, from 10.9 million returns to over 30 million returns. The amount of businesses filing as sole proprietorships saw an increase from 8.9 million in 1980 to 23.4 million in 2011. Partnership companies increased from 1.3 million returns to almost triple at 3.2 million returns. 

S corporations saw the most rapid growth, growing from 545,000 returns in 1980 to 4.15 million in 2011. This was an increase of over 660 percent, which was three times the rate of increase that pass-through businesses had overall. On the other hand, C corporations who filed tax returns during this time saw a decrease, going from 2.2 million returns in 1980 to over 1.6 million returns in 2011.

More Income is Now Earned From Pass-Through Businesses Than From Traditional C Corporations

When the amount of pass-through businesses started to increase, they generated an increased number of business income as a group compared to traditional C corporations. The total net income from S corporations, partnerships, and sole proprietorships in 1980 was $188 billion. This is compared to the combined C corporate net income, which was $697 billion. Net pass-through income saw a 340 percent increase by 1998, bringing it up to $829 billion. This overtook C corporate income for the first time, which was $773 billion. Pass-through business income has been steadily higher than corporate income since 1998. The exception to this is 2005, when corporate net income peaked at $1.6 trillion.

Pass-Through Businesses Make Up Most of the Private Sector

Pass-through businesses make more net income than regular C corporations do. However, they also make up for more employment. According to census data from 2011, pass-through businesses made up over 55.2 percent of private sector employment. This equates to 65.7 million workers. On the other hand, traditional C corporations made up 53.2 million workers or 44.7 percent of the private sector workforce. S corporations made up almost 25 percent of the private sector workforce, or a number that's equal to 29 million workers. Sole proprietorships employed 19.5 perfect of the private sector workforce, and partnerships accounted for only 11.3 percent.

Pass-Through Businesses Make Up a Majority of the Private Sector Workforce in Almost All States

The number of pass-through employment in the United States varies. Pass-through businesses made up over 60 percent of business employment in the following states: Maine (62.4 percent), Idaho (64 percent), Montana (67.9 percent), Rhode Island (60.6 percent), North Dakota (60.5 percent), Vermont (63.1 percent), South Dakota (64.7 percent), and Wyoming (61.8 percent). Hawaii (48 percent) and Delaware (49.5 percent) had pass-through employment as less than 50 percent of the total private sector.

A Large Portion of Employees in Service Sector Industries Are Employed by Pass-Through Businesses

Every industry has pass-through businesses that employ workers. However, there are bigger shares of pass-through employment in service sector industries than are in corporate employment. That said, trade and manufacturing industries are controlled by C corporate employment. Over 60 percent of pass-through employment is in the Entertainment, Arts, and Food Service (72.1 percent). The Utilities, Construction, and Transportation industries make up 60.8 percent, and the Information, Education, and Healthcare industries make up 60.3 percent. 

C corporations only made up a majority of employment in three industries: Manufacturing (63.7 percent), Retail and Wholesale Trade (58 percent), and Insurance, Finance, and Real Estate (50.6 percent). While they accounted for more employment in these industries, there were more pass-through businesses consistently in all of the industries.

Majority of Pass-Through Business Income Reported by High-Income Individuals

Pass-through business income will be taxed at the individual level, so distributing pass-through income across individuals is essential when understanding the effects it has on individual marginal tax rates.  If the majority of pass-through business incomes were earned by individuals of low to moderate income, the pass-through business income would see low marginal rates. However, if most business income is earned by those with a high income, pass-through business income would be taxed at possibly high marginal rates. The IRS reported that 72 percent of returns had business income reported between $1 and $100,000.

Types of Pass-Through Taxes

Small business owners will face two of the most common types of tax: sales and business income tax. Sales tax will be on some products and services based on your locality. Each state has different sales tax rules, and some don't enforce any sales tax. If sales tax does apply to your business, you will need to manage those obligations. Business owners don't pay sales tax out of pocket, but rather it is a percentage of the customer's total bill.

Sales tax will be collected from customers at the point of sale and sent to the government. Business income is defined as income received from business activities, which will be subject to taxes. Some businesses will have tax liabilities on business income pass through the company. The owner will pay taxes on business income with their personal tax return at their personal tax rate.

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