Reduce Your Business Taxes Like A Boss With A Pass-Through Entity

2016 has seen a lot of talk about the idea of lowering income tax obligations by the use of so-called "pass-through" entities. What are these entities, and how can you use them to smooth your own income taxes? Here's a brief primer on this tax method.

What are Pass-Through Entities? To begin with, it's important to know what is being talked about. A pass-through, or flow-through, entity is a type of business structure that allows the business' profits to be declared on the owners' personal income taxes and paid their individual rates. These entities are generally sole proprietorships, partnerships, LLCs (Limited Liability Companies), and S-Corporations. 

What is the Advantage? Paying business income tax through the personal taxes of its owners avoids what's commonly called "double taxation." In a standard corporation, the company pays taxes at a standard corporate rate. Then, when shareholders receive dividends or realize a capital gain on what they have earned from the business, they pay taxes again on their personal income taxes. A pass-through entity avoids this first level of taxation at the corporate level. It can also simplify filing since many sole proprietors can simply include a Schedule C with their annual tax filings. 

What about a Loss Carryforward? The idea of a loss carryforward is what has drawn attention to these business structures during the 2016 election cycle due to its highly-publicized use by a candidate. A loss carryforward is a tax strategy in which a person using pass-through income that loses money (expenses exceeded income) can use that loss to reduce their taxable income both in the past and in the future. Current IRS guidelines specify how you may use this "net operating loss" against other income you earned, so businesses often have leftover loss that can be used in other years. You should first recalculate the prior two years by using part of this loss each year, then use it in successive years (up to 20) until it runs out. 

How Can You Benefit from This? Pass-through entities are very popular these days because of advantages like lower average tax rates and loss carryforwards. If you are starting a new business, your income is likely to be volatile, so you may benefit from being able to use prior years' losses to adjust your taxable income once you begin making money. In addition, if you're in a seasonal or cyclical industry, it can help "smooth out" your taxes due from year to year.  

If you are thinking of starting a business as a pass-through entity, it's important that you work with a financial professional who understands business taxation. The advantages of this type of business structure can be many, but they usually require working with experienced help. But the result will be a larger profit, more confidence in your business, and less stress when it comes to tax time. 

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