Pass through taxation is exactly what it sounds like: the tax passes through an entity and on to the members or partners of that entity. The entity pays NO tax, only the partners or members do.
In a partnership, the entity earns profits on the business. These profits are distributed to partners in the business, who pay tax on those distributions. For example, “Texas Best Dentists Center” operates as a partnership. Over the course of the year, the business as a whole receives $500,000 in profit after expenses and maintenance. The two partners performing the work would receive $250,000 each. The partners each pay tax on the $250,000, while the partnership pays no tax.
Additionally, an LLC may be set up to take advantage of pass through taxation. Much the same as the partnership example, the profits of the LLC are not taxed to the LLC, but rather to the individual members on their returns.
However, entities can make a decision to make what is called an “S-Corp” election. An S-Corp election still allows for pass through taxation, but there are some differences in regard to how salary and distributions from the business are taxed. The big advantage of S Corporation elections comes in the avoidance of Medicare and Social Security tax—An owner who works as an employee may take a salary (where those taxes are taken out) as well as be given a distribution of other profits where those taxes will not apply. Without the S Corp election, that owner would be responsible for Self Employment Tax on the entire amount. S Corp elections can have great benefits for business owners, but also come with very strict business governance and maintenance issues that business owners should be aware of before making any kind of special tax classification election.
If you have questions about entity structure and management, San Antonio Business Attorney Nathaniel Gilbert can help answer your LLC and Partnership questions and get you pointed in the right direction. To learn more about Business Law and Management in Texas, Click Here. To contact Nate directly for a free consultation, Click Here.