When you own or invest in a business, you may receive distributions from its profits. Depending on how the business is structured, the company may not have paid taxes on these profits before distributing them to you. These businesses are known as pass-through entities. Here’s how pass-through income is taxed and what you need to know about it.
A financial advisor can walk you through different tax strategies to lower your liability.
What Is Pass-Through Income?
Pass-through income is the profits earned by a business that are distributed to owners and shareholders without the entity paying taxes. Taxes on profits are a normal part of business, but certain types of entities “pass-through” their income and avoid taxation. Although these business entities avoid taxes, whoever receives these distributions is responsible for paying taxes on those profits.
Which Business Entities Have Pass-Through Income?
Not all businesses qualify for pass-through income. The most common types of businesses that have pass-through income include:
In many cases, these business entities are closely aligned with a single business owner or a small group of investors. These entities pass along both the profits and the losses that a business may incur each tax year.
Who Pays Taxes on Pass-Through Income?
When a pass-through entity makes distributions to shareholders or partners, the recipients are the ones who pay taxes on those profits. In most scenarios, these distributions are labeled ordinary income for tax purposes.
For example, if two siblings are equal partners in a business. Although the partnership must file a tax return, it is not required to pay taxes. Instead, each sibling is responsible for paying taxes on their share of the income.
How Is Pass-Through Income Taxed?
Pass-through income is taxed as ordinary income, which are generally the highest tax brackets that taxpayers pay. In 2022, ordinary income tax rates range from 10% to 37%. The tax rate that applies to your income depends on your filing status and how much you make.
High-income taxpayers may also owe a “net investment income tax” of 3.8% on unearned income. Depending on how you earned the pass-through income, it could be subject to this additional tax burden. Additionally, it could push your adjusted gross income high enough where other sources of income must also pay these extra taxes.
How Can Pass-Through Income Reduce Taxes?
With the Tax Cuts and Jobs Act of 2017, business owners of pass-through entities may qualify for up to a 20% tax deduction on eligible income. This tax deduction allows eligible business owners to deduct up to 20% of their Qualified Business Income (QBI). Plus, they can also deduct 20% of qualified REIT dividends and qualified publicly traded partnership (PTP) income. QBI is also known as a Section 199A deduction.
Can You Reduce Taxes on Pass-Through Income?
Because pass-through income is taxed as ordinary income, investors have a strong incentive to incorporate tax-reduction strategies into their financial plan. If you need to reduce your taxable income, here are six common strategies to consider:
- Create or contribute to a company retirement plan. If you have a job that offers a company retirement plan like a 401(k), contribute as much as possible. For investors who own a business, consider creating your own company retirement plan.
- Maximize individual retirement accounts (IRAs). Contribute the maximum to a Traditional IRA for you and your spouse. Be aware of income limitations for you or your spouse if either of you has access to a company retirement account at your workplace.
- Health savings accounts (HSAs). HSAs require a high-deductible medical insurance policy, so look at your medical needs first. These accounts offer triple tax-advantages – a tax deduction now, the money grows tax-deferred, and it can be withdrawn tax-free for eligible medical expenses.
- Purchase tax credits. Tax credits reduce your taxes owed dollar-for-dollar for the amount that you invest.
- Minimize taxable income on investments. Reduce your taxable income by placing income-producing investments into tax-advantaged accounts. For example, REITs and bonds have regular distributions that increase your taxable income. The best option is to hold these investments in a retirement account.
- Realize losses on investments. If you have investments that are worth less than you’ve paid for them, consider selling them to realize the losses to offset your income. You can offset an unlimited amount of capital gains and up to $3,000 of ordinary income each year.
Pass-through income avoids taxation at the business entity level. Instead, the profits are distributed to business owners, shareholders, and partners as ordinary income. Ordinary income rates are generally the highest tax rates a taxpayer will pay, but there are ways to reduce your taxable income. Speak with your tax professional and financial advisor to discover ways to reduce your taxes.
Tips for Lowering Your Taxes
- A financial advisor can help you optimize your financial plan to lower your tax liability. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- To lower your taxes, it helps to forecast what your tax obligations may be. SmartAsset’s federal income tax calculator estimates how much you owe in taxes based on your income, location, filing status, and deductions.
Photo credit: ©iStock/shih-wei, ©iStock/damircudic, ©iStock/Viorel Kurnosov