Question

The new tax law changes corporate tax rate to a lower 21%, it also changes some thresholds of the “pass-through” entities. For example, business owners may deduct 20% of their QBI (qualified business income).

Explain why partnerships and S corporations are considered “pass-through” entities and present an example of how the pass-through works.

Answer 1

Partnerships and S Corporations are considered as Pass Through Entitties because any business income earned by them are taxed at their owner's or shareholders level and not at the entity level. However this is subject to consideration of reasonalble Employement Remuneration to the owner which is subject to Social Security and Medicare taxes.

There is no federal income tax levied at the Corporate Level for S Corporations. Instead its profit is allocated to its shareholders and taxed at the shareholders level. The benefit is that the Business Income is not subject to normal payroll taxes.

Example: Jack is owner of S Corp which is an Advertising Agency. It earns $100,000 as annual income. It apays Jack Salary of $70000.

Here $30000 is the profit of S Corp after considering $70000 as reasonable salary for Jack. Now for jack, $70000 would be taxed normally and subject to Payroll taxes or Employment Taxes, whereas $30000 would also be taxed normally but would not be subject to payroll taxes.