Many digital nomads look at solutions to optimize their taxes. Often, they end up looking at entities who benefit from pass-through taxation. However, you need to properly understand the consequences to ensure such a setup is actually beneficial for you.
Key Takeaways
- Pass-through taxation allows you to pay all taxes on a personal level.
- Opposed to this, you can also use a structure with double taxation.
- You can find most pass-through entities in Anglo-Saxon jurisdictions.
- Although pass-through structures come with benefits, you don’t want to lose potential disadvantages out of sight.
- In order to determine your perfect setup, the most important is to compare the total tax burden.
What is Pass-Through Taxation?
Pass-through taxation applies when you don’t pay taxes on the level of your business but at your personal level as the owner or shareholder.
So, basically your business is disregarded for taxes. The tax liability for the business income will fall on the individual who owns the business. From that perspective, the taxation is similar to when you operate under a sole proprietorship in your personal name.
Accordingly, you need to report any business income and expenses in your individual tax return.
Types of Pass-Through Entities
Pass-through taxation is mainly known in Anglo-Saxon countries. Therefore, we can find the most prominent types of flow through entities there. Let’s have a look at the most prominent examples.
US LLC
The most well-known pass-through is definitely a Limited Liability Company in the United States.
Many digital nomads look at this solution for their business setup.
If you want to learn more about the details I would suggest to have a look at this article about the digital nomad LLC.
US S Corporation
Another pass-through according to US law is the S Corporation.
Just like the US LLC, the S Corporation benefits from pass-through taxation.
Please make sure that you don’t confuse the S Corporation for a C Corporation. The latter is subject to corporate tax.
UK LLP
An alternative for these structures in the US can be found in the Limited Liability Partnership in the United Kingdom.
Canadian LP
Another alternative is the Limited Partnership in Canada.
Benefits of Pass-Through Taxation
Let’s take a closer look at the benefits of tax transparency and why people opt for such a business setup.
Pass-Through Taxation to Avoid Double Taxation
The most common benefit of pass-through taxation is that you only pay taxes on one level.
You’ll declare the income in your personal name and pay taxes on it.
If you operate under a business, you’ll pay taxes on two levels and double taxation occurs. First, your company will pay corporate tax. Next, you’ll pay out your profit after tax and pay a dividend tax on your personal level. Accordingly, the same income is taxed twice.
You can read more about pass-through taxation vs double taxation here.
Limited Liability
Although you pay your taxes on your personal level, there is still a separation between you personally and the business.
This will most of the time allow you to still limit your liability in case something goes wrong and your clients want to get recourse.
Therefore, transparent taxation allows you to limit your liability while still avoiding to pay corporate tax.
Considerations and Potential Drawbacks
Yet, using pass-through taxation is not a fix all. There are some attention points you should know about.
Total Tax Burden
As discussed before, by using a pass-through entity you will only pay taxes on a personal level. For this reason, many people think that pass-through taxation is by default better than a setup with a company subject to corporate tax.
However, this couldn’t be further from the truth.
To determine which option will be best for you need to compare the total tax burden in case of a setup with pass-through taxation on the one hand and double taxation on the other hand.
In case of pass-through taxation, you’ll pay personal income tax on your business income. However, on top of this you’ll also have to pay social contributions. In many countries, these can be rather high.
In case of double taxation, the most important parameters will be the corporate tax rate and the dividend tax.
Only if you make a proper comparison you’ll know what will work best for you.
Tax Treatment Pass-Through Income
If you want to understand if a structure with pass-through taxation is interesting for you, you need to understand the tax treatment of the pass-through income.
You need to figure out how – and at what rates – the income is taxed on your personal level. Most of the time, it will be subject to the income tax rates for professional income.
However, the exact tax treatment will depend on your country of tax residency.
How to Take Advantage of Pass-Through Taxation?
If you want to take advantage of pass-through taxation, it needs to fit in your overall tax strategy.
As discussed before, pass-through can come with advantages. However, there are also attention points to be aware of.
Reach out if you need assistance with putting together your tax strategy. I have helped hundreds of digital nomads with optimizing their tax setup.