Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Pass-Through Income

What it is:

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 it works (Example):

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 it Matters:

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.

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