My clients sometimes ask me: Why am I paying the tax and not my business?
In today’s post, I’ll explain pass-through taxation and how it affects your individual tax liability.
Why am I paying the tax and not my business?
Let’s start with the basics. When you open a business, it becomes a separate legal entity from you, even though you own and operate it. This distinction is important for legal and financial purposes. Your business is considered an independent entity in the eyes of the law, with its own assets, liabilities, and obligations.
However, if you’re like most American small business owners, you likely own a business that qualifies for pass-through taxation. Owners of sole proprietorships, partnerships, limited liability companies (LLCs), and S-Corporations often choose to put themselves in this category (and for good reason!). But sometimes, the business owner doesn’t understand the why behind this structure and come tax time, they’re left wondering why they’re paying taxes that they feel like their business should be paying.
If this is you, I understand why you might feel this way, but as long as you’ve set up your business correctly and have followed proper procedures for bookkeeping and filing taxes, then pass-through taxation is likely saving you tax money.
What is pass-through taxation?
If your business is structured to allow for pass-through taxation, this means that the business’ profits and losses are passed through to you as the owner. In other words, the business itself doesn’t pay income taxes directly. Instead, the profits “flow through” to your personal tax return, and you pay taxes on that income at your individual tax rate.
The concept of pass-through taxation is why you might see an increase in your personal tax liability due to your business’ earnings. It may also be what makes you ask, Why am I paying the tax and not my business?
Here’s a simple breakdown of how pass-through taxation works:
No Entity-Level Tax: Unlike C-Corporations, which pay corporate income taxes on their profits, your pass-through entity doesn’t pay income taxes at the business level. Instead, the business’ income goes directly to you through wages and distributions.
Individual Taxation: You’ll report the income that passes through to you on your individual tax return. Your business income is combined with any other sources of income you have, such as wages, interest income, or dividends.
Taxation at Individual Rates: The pass-through income is then taxed at your individual income rate, which varies based on your total income and tax bracket. The tax rates for pass-through income are typically the same as regular income tax rates.
Why would I want pass-through taxation?
Most small business owners and entrepreneurs choose pass-through taxation because it simplifies the taxation process at the business level. Even more importantly, pass-through taxation eliminates double taxation that applies to C-Corporations.
Double taxation happens when a C-Corporation pays taxes on its annual profits and then shareholders pay taxes on those same profits when they receive their share of the dividends.
What is pass-through entity tax?
When the Tax Cuts and Job Acts was passed in 2017, it placed a $10,000 yearly limit on the amount of deductions individuals can claim on their federal tax returns for their state and local taxes (SALT) through 2025. This is known as the SALT cap.
In response to this, more than 30 states and New York City have put into place or are currently proposing a workaround called pass-through entity tax (PTET). PTET allows certain businesses to elect to pay their state tax at the entity level. Depending on the state, this voluntary election allows the business owner to either claim a refundable tax credit or exclude their share of the business income on their individual state tax return.
The biggest benefit to a PTET election is that the business owner can then deduct the state income tax paid through the PTET from their federal taxes. Since there is no federal limit to the amount of PTET that is deductible, this allows the business owner to avoid the SALT cap and potentially save lots of tax money.
PTET regulations vary by state and can become complex when dealing with partnerships or with businesses where the owner’s resident state is not the same as the state where the business pays taxes. It’s best to work with a certified public accountant (CPA) to make sure that making the PTET election is in your best interest.
How much money can pass-through taxation save me in taxes?
When it comes to pass-through taxation at the federal level, how much money you will or won’t save in taxes depends on many different factors. Let’s look at an example to see how this works using real numbers.
Lindsey is a wedding photographer who owns an LLC with an S-Corporation election, which means Lindsey’s business is a pass-through entity. Last year, Lindsey’s business generated $120,000 in profit. Lindsey worked with me, her accountant, to determine that her reasonable compensation (salary) should be $50,000.
This means that after Lindsey’s wages, the business’ remaining $70,000 in profits are passed through the S-Corporation and reported as S-Corporation profit on Lindsey’s personal income tax return. There’s no Social Security or Medicare tax on this $70,000 because it’s not employee wages.
The S-Corporation election means that Lindsey only pays income tax on some of her company’s profits rather than self-employment tax (Social Security and Medicare) and income tax on the entire $120,000. In this case, the pass-through entity status saves $10,710 in taxes.
|Yearly Net Income
|Social Security Tax
Does pass-through taxation definitely mean I’ll pay less in taxes?
It’s important to note that pass-through taxation might not always result in lower tax liability. In some cases, depending on your income level, the taxes paid on pass-through income could be comparable to or even higher than what you would pay if your company wasn’t set up to have pass-through taxation.
Additionally, the rules and regulations surrounding pass-through taxation can be complex. It’s definitely a good idea to consult with a tax professional to ensure you’re making the right choice for you and your business.
Why am I paying the tax and not by business is a question that often comes up when business owners are looking over their tax bill. If this has entered your mind, just remember that pass-through taxation is designed to simplify the tax process and hopefully save you money in taxes.
If you want to learn even more ways that you can lower your tax burden, read through my other articles on the topic: