What is Pass-Through Income?

home-office pass-through incomeWith the passage of the new tax bill at the end of last year, there’s been a lot of talk about the tax breaks that were bestowed on both corporations and on small businesses through what is known as “pass-through income.” There have been a number of questions raised as to who will be affected by this and how, so let’s take a look at what pass-through income is and what the impact of the new business law will be.

Pass-through income describes the way that businesses including sole proprietorships, partnerships, S-corporations and limited liability companies address their taxes. Rather than paying a corporate tax, the income generated by these businesses passes through to the individual business owner’s tax return as personal income. This means that those businesses’ tax rates are whatever the individual’s personal rate is calculated to be. Though most consumers may believe that most of the businesses in the United States pay their taxes at a corporate rate, that is only true of about 8 percent of businesses. About half of all businesses set up as corporations in the United States are set up as S-corporations (which pay a pass-through rate), another 8 percent are set up as partnerships, and another 70 percent are set up as sole proprietorships. This means that the vast majority of businesses are paying their taxes using a pass-through rate.

The good news for these businesses is that under the recently passed tax reform act, their taxes will be significantly cut. Individuals that own pass-through entities have been given a 20 percent deduction on taxable income: this means that they can reduce their income by one-fifth before calculating their taxes. There are some exceptions, including capping the deduction at either half of the company’s total wages as reported on employee W-2s by a formula calculating wages and capital investment. The business law also states that the deduction isn’t available for those providing a service where the principal asset is the skill of one or more of its employees or owners. But for individuals whose taxable income falls below the 24 percent tax bracket, those limits don’t apply, and neither does the professional services limitation.

The way that the new tax law impacts your business can be challenging to understand. To speak with a business law professional to determine whether it makes sense for you to reorganize your business, contact us today.