You may have heard about the advantages of “pass-through taxation” when discussing certain types of business entities with your neighbors, other producers, your lawyer, or accountant. But what exactly does pass-through taxation mean?
To explain pass-through taxation, we have to begin at the different types of business entities. The simplest business entity is the sole proprietorship. This is when a person does not have a distinct business but rather, just combines business income with personal income. The taxes due for the business income are included on the person’s personal income tax information. This is pass-through taxation — the tax passes through to the person’s own income tax and the business itself does not pay taxes.
A slightly different idea, but the flip-side to pass-through taxation, is the “double taxation” problem. This is when a corporation, known as a C-Corp, first pays income taxes and then shareholders also pay taxes on any gain or dividend the shareholder receives.
Pass-through taxation avoids the double taxation problem. The income from the pass-through business entity “passes through” to the individual(s) who have shares/ownership/income interests in the business entity and the individual then reports the income on their own federal income tax return.
It is always worth consulting your CPA for the finer details and possible outcomes when making a choice of entity decision for your operation. However, it is worth knowing some of the terms of art with regards to business entities and pass-through taxation is one of the cornerstones. There is nothing wrong with exploring all possible options for the type of entity for your operation and exploring any possible tax advantages or consequences; you never know unless you ask about pass-through taxation!