Pass-Through Businesses and Income Taxes
Some businesses pass their earnings and losses to their owners, who pay income taxes on their share of the business’s taxable income. These are called “pass-through” taxes. Businesses that are pass-through tax entities:
Sole proprietorshipsLimited liability companiesPartnershipsS corporations
Here’s an explanation of how pass-through taxes work:
Self-Employment Tax for Business Owners
Owners of pass-through businesses also must pay self-employment tax (Social Security/Medicare tax) on their business income. S corporation owners are an exception; they don’t have to pay self-employment tax.
How a Sole Proprietor Pays Income Tax
A sole proprietorship is the simplest form of business in the U.S. You’re a sole proprietor if you’re self-employed or an independent contractor unless you’ve registered as another form of business entity. A sole proprietorship is more or less formed by default when you don’t take steps to register as another type of enterprise but you’re in business for yourself. Sole proprietors complete Schedule C to determine their taxable business income after deductions. The income resulting from Schedule C is transferred to the owner’s personal tax return and tax is paid at the owner’s personal tax rate. Sole proprietors must also file Schedule SE and pay the self-employment tax—the equivalent of the Medicare and Social Security taxes that would otherwise be shared with their employer if they worked for someone else. You should make quarterly estimated tax payments throughout the tax year if you’re a sole proprietor because the IRS prefers that you pay as you earn. This involves filing Form 1040-ES.
How a Partnership Pays Income Tax
A partnership is a result of two or more individual taxpayers joining together for business purposes, and they share in both the profits and the losses of the business. Partnership businesses don’t pay income tax directly to the IRS. Rather, the partners are taxed on their shares of the partnership’s income. Partnerships calculate their business income or loss on Form 1065, and the individual partners then receive Schedule K-1’s showing their shares of this income. Schedule K-1 is included with the owner’s personal tax return and taxes are paid at the owner’s personal tax rate, just as they would be if they were sole proprietors. Partners must also pay the self-employment tax and make quarterly estimated tax payments.
How a Limted Liability Company (LLC) Pays Income Tax
The IRS will recognize LLCs as a corporation, partnership, or a “disregarded entity,” which means the LLC’s taxes are part of the owner’s tax return. This can depend on how many owners the business has (referred to as “members”). Members can be individuals or other business types, such as a corporation. A member in a single-member LLC files taxes as a sole proprietor does, using Schedule C and Schedule SE. As with a sole proprietorship, the income of the business is transferred to the member’s personal tax return. LLC members should also pay quarterly estimated taxes.
How a Corporation Pays Income Tax
A corporation is its own separate tax entity, and it pays income tax at the corporate tax rate. The owners of the corporation are shareholders, and they receive income in the form of dividends. They pay taxes on this income at the dividend rate. This can result in double taxation. The business is paying taxes on its earnings at the corporate level, and shareholders are again paying taxes on the dividends they receive. Capital gains on the sale of shares can also be taxed at the individual level. Some shareholders might also be executive employees of the corporation. These employees receive a salary and this income is taxed just as it would be for any other employee.
How an S Corporation Pays Income Tax
An S corporation passes income, taxes, credits, and deductions down to its owners. The owners pay taxes at their personal tax rates. The S corporation does not itself pay taxes, unlike a corporation, so there’s no double taxation. The tax paid by the owners or shareholders is determined by the total amount of the tax that would be owed by the S corporation were it required to pay taxes. This total is then divided among the shareholders based on their percentages of ownership. The corporation files a tax return using Form 1120-S to report income passed down to shareholders, and individual owner shares are reported on Schedule K-1.
