I often get a lot of questions about pass through entities and how taxation actually works. There are a lot of folks with a lot of misinformation. Let’s clarify what a pass through entity is: you have tax return information for a business that is flowing through your personal tax return. For most of the business owners in the US, that will be the case unless you operate under a C corporation structure. Let’s just assume for a moment that you are a pass through entity. When we talk about pass through entities, you will pay income taxes on your income that you earn less the expenses that you pay. Notice that when I said that, I did not say you will pay taxes on how much money is in your bank account at the end of the year. You will not.
Let me give you two examples of two separate businesses so that you can see the difference. For example, I have a business that made $500,000, and I had $100,000 worth of expenses that were paid. When we talk about income and expenses, we’re generally talking about a cash basis taxpayer. That means you received the money and you paid out the expenses. If that’s the situation, there would be $400,000 worth of profit leftover. That profit, if it’s in a pass through entity, means that it would be taxed. You personally pay taxes on $400,000 worth of profit.
Now let’s say that in my business, I make that $400,000 and I use every penny of it all throughout the year to support my lifestyle and to pay all my bills. So I take that money out and at the end of the year, the checking account just says a hundred dollars left in it for the business.
My friend has the same exact business model and makes the $400,000, but has a spouse who is supporting all of their personal bills and other expenses. So they don’t use the money. They leave $400,000 in the checking account of the business at the end of the year. Who pays more in taxes? That’s a trick question — We pay the same. We pay taxes based on the income, less the expenses. It does not matter how much money is left in the bank. We don’t pay taxes on the cash balance of her checking account. It’s not income and it’s not expense. If we take the money out of the business, that’s an equity position transaction so we’re taking a draw or distribution that does not have any effect on taxes.
**If you do take out more money than you earned, there may be tax consequences for taking out that excess funding, but in normal situation, you pay taxes on income, less expenses. It doesn’t matter if you left the money in the business or took the money out. Distributions and draws are basically the same thing. A draw relates to a sole proprietorship while a distribution relates to an S corporation or a partnership. I hope that helps you clarify how taxes work with a pass through entity.
Donna Bordeaux, CPA with Calculated Moves
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