What You Want to Know: Cash & Pass Through Income

What do you mean I owe tax? I didn’t get any cash!

Welcome to the world of cash distributions versus pass-through income of an entity. Confused yet? Stick with us on this. It’s important.

This is a common question for owners of pass-through entities. A pass-through entity is a fancy tax term which boils down to that a business doesn’t pay income tax. Rather, the profits “pass through” the company to the owners. We’re talking here about organizations structured as S-corporations, partnerships or LLCs.

It’s a pretty common misconception that income tax is paid on cash distributions from the business. And yes, this is partly true. There are certain instances where cash distributions from partnerships or S-corporations are taxable. But the majority of the time, this is simply not the case.

As an owner of an S-corporation or partnership, you are taxed on the activity of the business, which is reflected as income or losses on the Schedule K-1 issued with the business tax return. It is possible for a business to generate taxable income and have no cash distributions to owners. So you would still have to pay income tax, regardless of if you received cash distributions or not.

Common reasons for this include:

  • Cash is used to pay down debt
  • There is income attributable to uncollected accounts receivable
  • Business expansion

And to complicate things even further, it’s also possible for a business to have losses, yet still issue owner distributions. This is most commonly due to depreciation and other non-cash expenses. Another reason is collection of accounts receivable included as income in prior years.

The moral of the story is that taxes are rarely straightforward. So even if you didn’t receive a cash distribution, there’s still the potential tax is owed. The best way to know for sure is to consult with your tax professional. They’ll help you see what’s coming round the bend and then, even if you owe, you hopefully won’t be surprised by it.

Entity Selection

Entity SelectionIt’s a new year with a new set of resolutions. Which will you conquer first? One of the first things to cross off your list when starting a new business is selecting your entity type. Do you want an S-corp, C-corp, LLC, GP, LP, LLP, LLLP, Sole Proprietorship?  Should your LLC elect to be treated as an S-corp or a C-corp? Does it really make a difference?

Of course there are different legal ramifications for each entity type, which should be discussed with an attorney, but there are different tax ramifications as well.  It is possible to change entity type down the road, but it may be costly to do so.  Here is a short, non-inclusive list of items to consider.

  • How will you capitalize the business? In other words, how are you getting money? Will you contribute your own outside assets?  Will you bring in outside investors?  IPO?
  • How will profits/losses/distributions amongst owners be handled?  Based on ownership or will there be a preferential return for certain investors/owners?
  • What are your plans for future disposition of the business? In other words, what’s your end game?
  • What is your business type?  What kind of assets does your business own?
  • Will the business be making distributions to the owners?
  • How will owners be compensated for services provided to the business? (Also, owners may be treated differently than other employees in terms of compensation and benefits.)
  • Is it beneficial to use the business losses on the owners’ personal tax returns?
  • In what state(s) do you operate?
  • What are current and expected tax rates?
  • What are the complexities and administrative requirements?

As you can see from the list above, this is not an easy process. In fact, it’s complex and has several facets to consider before you make the decision. So don’t jump at the first entity type that catches your eye. Instead, take time to look and see what’s the best match for where you want to go with your business.