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.