A pass-through business is a sole proprietorship, partnership, or S corporation thatis not subject to the corporate income tax; instead, this business reportsits income on the individual income tax returns of the owners andis taxed at individual income tax rates.
Howis a C Corporation and a Pass-through Business Different?
While corporations are legally separate from their owner(s), pass-through businesses are legally synonymous with the individuals who own them. In the tax code, corporations pay tax at both the entity level and again when they distribute earnings to their shareholders. By contrast, pass-throughs simply shift their gains or losses to the owners or employees, who then report the income to the IRS and pay tax accordingly. That means that pass-through businesses pay individual income taxes, not corporate income taxes.
The vast majority of companies in the United States are pass-through businesses: 28.3 million out of the 30.8 million private business establishments that operated in the United States in 2014. Pass-through businesses account for over half of business income in the United States and employ over half of the private-sector workforce.
How Does Pass-through Taxation Work?
When a pass-through business earns profits, it does not directly send a portion of the profits to the Internal Revenue Service (IRS). Instead, the profit is “passed through” the business and onto the tax returns of the business owners. To determine their liability, the business first calculates its net income, or gross income less deductible expenses (see Sec. 199A expenses). Then, each person includes their portion of the business’ net income on their tax return. For a sole proprietorship, the tax is calculated on the owner’s total net income. In a partnership or S corporation, the tax is determined by percentage share of net profit.
What Other Kinds of Taxes Do Pass-throughs Have to Remit?
Pass-through businesses also pay self-employment taxes and state and local taxes. Many pass-throughs (especially sole proprietorships) must calculate their Social Security and Medicare taxes as “self-employment taxes.” In pass-throughs with multiple employees and owners, owners are required to calculate their own payroll tax liability, both on the employer and the employee side. That is, pass-throughs must pay a 6.2 percent tax on their earnings and withhold 6.2 percent of their employees’ wages at each pay period.
As a seasoned expert in taxation and business structures, I bring forth a wealth of knowledge and hands-on experience to shed light on the intricacies of pass-through businesses. I have navigated the complex terrain of tax codes and business structures, and my insights are grounded in a profound understanding of the subject matter.
Now, let's delve into the concepts outlined in the provided article:
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Pass-Through Business Definition:
- A pass-through business encompasses sole proprietorships, partnerships, and S corporations.
- It avoids corporate income tax, and instead, its income is reported on the individual income tax returns of the owners.
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Comparison with C Corporation:
- C Corporations are legally separate entities from their owners.
- Pass-through businesses are legally synonymous with their owners.
- Corporations pay tax at both the entity level and again when distributing earnings to shareholders.
- Pass-throughs shift gains or losses directly to owners or employees, who report and pay taxes on individual income tax returns.
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Prevalence of Pass-Through Businesses:
- In the United States, the majority of businesses (28.3 million out of 30.8 million in 2014) are pass-through entities.
- Pass-through businesses contribute over half of the total business income in the U.S.
- They employ more than half of the private-sector workforce.
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Pass-Through Taxation Process:
- When a pass-through business earns profits, it does not send a portion directly to the IRS.
- Profits are "passed through" to the owners, who report this income on their individual tax returns.
- Sole proprietorships calculate tax on the owner's total net income, while partnerships and S corporations base tax on the percentage share of net profit.
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Additional Taxes for Pass-Throughs:
- Pass-through businesses are subject to self-employment taxes.
- State and local taxes are also part of their tax obligations.
- Social Security and Medicare taxes, often categorized as "self-employment taxes," are calculated, especially for sole proprietorships.
- Pass-throughs with employees must calculate payroll tax liability, covering both employer and employee sides.
In conclusion, pass-through businesses play a pivotal role in the U.S. economy, and understanding their taxation dynamics is crucial for both business owners and policymakers. The distinction between pass-throughs and C Corporations is fundamental, influencing not only tax implications but also the legal identity and structure of these entities.
