Pass-Through Income

What is Pass-Through Income?

Pass-through income is sent from a pass-through entity to its owners. The income is not taxed at the corporate level -- it is only taxed at the individual owners' level.

A pass-through entity is a special business structure that is used to reduce the effects of double taxation.

How Does Pass-Through Income Work?

Company XYZ is a pass-through entity. It files a tax return that looks like this:

Revenues                                                            $1,000,000   
Expenses                                                                (500,000)             
Earnings Before Interest & Taxes (EBIT)                 500,000
Interest Paid                                                           (100,000)
Earnings Before Taxes (EBT)                                  400,000
Taxes                                                                           ------ 
Net Income Available to Owners                               400,000

XYZ has two owners, Jane and Bill, who each own 50% of the company. XYZ sends both Jane and Bill an IRS Schedule K-1 that reports their portions of XYZ's pass-through income. Jane and Bill each file their own tax return with $200,000 reported as income. It is important to note that Company XYZ allocates the income to Jane and Bill regardless of whether the $400,000 in Net Income is actually distributed.

Losses are also passed-through to owners, but the total deductible amount available is limited to the original investment amount.

Why Does Pass-Through Income Matter?

Pass-through income can make for a confusing tax situation, depending on the complexity of company operations. Furthermore, sometimes pass-through income is not actually distributed to shareholders, leaving the owners with a tax burden but no cash with which to pay it.

For example, assume that Jane's tax burden ends up being 20% of $200,000 for tax year 2009. She owes the IRS $40,000, but XYZ did not make a distribution in 2009, and there is a possibility that it will not make a distribution in 2010, either. Jane is now responsible for taxes owed on income that she did not actually receive.