Pass-through income: From your business to your tax return

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The income passes through. The tax bill follows.

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Many U.S. businesses are organized as pass-through entities, meaning they generally don’t pay federal income tax as businesses. Instead, the income “passes through” to the owners, who report it on their personal tax returns. That income is often called pass-through income, and the taxes owners pay on that income are commonly referred to as pass-through taxation.

That sounds simple enough, but pass-through taxation can create surprises. Depending on your business structure, income may be reported on Schedule C or Schedule K-1, and you may owe tax on business income even if the cash stays in the business rather than being distributed to you.

In a pass-through entity, business profits generally aren’t taxed at the business level. Instead, they flow through to the owners, who report the income on their personal tax returns.

For example, if a partnership earns $100,000 and allocates $50,000 apiece to its two partners, each partner may owe tax on $50,000 of income even if the partnership keeps the cash in its bank account rather than distributing it.

A sole proprietorship is the simplest type of pass-through business. For tax purposes, the business and its owner are generally treated as the same taxpayer.

Most sole proprietors use the cash method of accounting, which means income is recognized when payment is received and expenses are recognized when they are paid. Business income and expenses are reported on Schedule C and included on the owner’s Form 1040. Net income is generally taxed at ordinary income tax rates and is also generally subject to self-employment tax, which is calculated on Schedule SE.

As a sole proprietor, you can generally transfer money between your business and personal accounts whenever you choose. But those transfers don’t determine when income is taxed. If your business earns income this year and you leave some of the cash in the business account to cover future expenses, you’ll generally still owe tax on that income in the year it was earned.

In a partnership, business income generally passes through to the owners rather than being taxed at the business level. Partnerships file Form 1065 to report income, deductions, gains, and losses. Each partner receives a Schedule K-1 showing that partner’s share of taxable income and other tax items.

Partners report the information from Schedule K-1 on Schedule E of their Form 1040 and generally pay tax at their individual income tax rates. Depending on the nature of the partnership interest and the owner’s role in the business, some or all of that income may also be subject to self-employment tax.

Limited liability companies (LLCs) are legal entities rather than tax classifications. Depending on the number of owners and any tax elections made, an LLC may be taxed as a sole proprietorship, partnership, S corporation, or C corporation.

One important feature of partnership taxation is that taxable income and cash distributions don’t always match. Partners may owe tax on income reported on Schedule K-1 even if the business retains the cash for future expenses, expansion, or other business needs.

An S corporation isn’t a business structure; it’s a certain tax status election filed with the IRS. Although an S corp is legally a corporation, it’s generally taxed more like a partnership. S corps file Form 1120-S, and each shareholder receives a Schedule K-1 reporting their share of the company’s income and other tax items. Shareholders generally report that information on Schedule E of Form 1040.

Because income reported on Schedule K-1 generally isn’t subject to self-employment tax, owners who work in the business generally must be paid a reasonable salary. This compensation is reported as wages on Form W-2 and is subject to payroll taxes.

As with other pass-through entities, S corp owners generally pay tax on the income reported to them, regardless of how much cash they receive in distributions. They also pay tax on any wages reported on Form W-2.

One tax benefit available to many owners of pass-through businesses is the qualified business income (QBI) deduction, also known as the Section 199A deduction. Eligible taxpayers may deduct up to 20% of their pass-through business income, reducing the amount of income subject to federal tax.

Sole proprietorships, partnerships, and S corps may qualify for the deduction, but C corporations do not. The deduction is claimed on Form 8995 or Form 8995-A and is subject to income limits and other restrictions. In general, the deduction can’t exceed 20% of taxable income minus net capital gain.

Many states generally follow the federal approach to pass-through taxation. Traditionally, the business doesn’t pay state income tax; instead, the owners report and pay tax on their share of the income on their state returns.

After the Tax Cuts and Jobs Act of 2017 limited the federal deduction for state and local taxes (SALT), many states began allowing pass-through businesses to pay state income tax through a pass-through entity (PTE) tax. Under a PTE tax, the business pays the tax rather than passing the obligation to its owners.

Rules vary by state, but pass-through entity taxes are now common.

Unlike sole proprietorships, partnerships, LLCs taxed as partnerships, and S corporations, corporations (C corps) generally pay tax at the corporate level. If the corporation distributes some of its after-tax profits as dividends, shareholders may also pay tax on those dividends, which are generally reported on Schedule B of Form 1040. Because the same earnings may be taxed at both the corporate and shareholder levels, this phenomenon is often referred to as double taxation.

If you own a pass-through business, the income your business earns is generally reported on your personal tax return rather than taxed at the business level. Depending on your business structure, that income may be reported on Schedule C, Schedule K-1, or Form W-2. Because pass-through income is generally taxed when it’s earned—not when cash is distributed—you may owe tax even if some of the money remains in the business.