Pass-through taxation vs double taxation is something many nomads keep making mistakes about.
The reason seems to be that they don’t fully understand the difference between those two tax systems. As a result, they jump into a setup of which they only find out later they don’t understand all the consequences. Let’s have a look at what you actually need to know about this.
Pass-Through Taxation vs Double Taxation In Short
If you incorporate a company two systems of taxation can apply. The first is pass-through taxation and the second is double taxation.
From a tax point of view the difference is massive. Each system has its own set of rules that apply. Consequently, the actual taxes you’ll pay in either situation will also differ very much.
What is Pass-Through Taxation?
Pass-through taxation occurs when you don’t pay income tax on the level of your business but on a personal level instead.
This approach is also called flow-through taxation, tax transparency or we call a company subject to it a disregarded entity.
So, you have a business in place through which you operate. However, that business itself isn’t subject to tax. Rather the tax assessment is made on the level of the owner(s) of the business who needs to report the income in his personal tax return.
Therefore, the owner will pay taxes on the earnings and can offset any tax credit or tax deduction against it. Moreover, the income is also used to calculate your social contributions or self-employment tax.
The benefit of this approach is that you only pay income tax once on the income you make through your business. Nevertheless, this doesn’t necessarily mean that you’ll pay less tax than when double taxation applies.
Example of Pass-Through Taxation
The best known example of pass-through taxation is probably the single member US Limited Liability Company.
Many digital nomads look at setting up a US LLC but don’t fully understand the technicalities from a tax point of view.
If you own a single member US LLC, you don’t pay any income tax on the level of the US LLC itself. The reason for this is that the US tax laws treat the LLC as a pass-through entity. Accordingly, the income passes through it to the beneficial owner of the LLC.
Therefore, you need to assess the tax consequences on the level of the owner of the company.
If you are a US taxpayer, you will have to include the income of the US LLC in your personal tax return in the United States. Consequently, you’ll pay personal income tax on the income in the US.
Nevertheless, most digital nomads starting a US LLC are not US taxpayers. Therefore, they don’t have to pay any taxes in the US on the level of the LLC, nor on a personal level.
Yet, that doesn’t mean that you don’t have to worry about taxes at all.
You might still owe income tax on the income from the LLC in the country where you have your personal tax residency. This will actually be the case most of the time.
Nonetheless, there are some set-ups where you can end up paying very little to no tax at all with a US LLC.
Types of Pass-Through Entities
Hereby a list of some popular entities which can benefit from pass-through taxation:
You’ll notice that these kind of business types mostly exist in Anglo-Saxon countries.
What is Double Taxation?
If we talk about double taxation in this context we are talking about a setup whereby you pay taxes on two levels.
On one hand the company pays corporate tax on its profit. This leaves us with the profit after tax. Next, the company can pay this net profit out to its shareholder(s) as a dividend. However, in this case the shareholder will have to pay dividend tax on the dividend.
Accordingly, the same income is taxed twice. First on the level of the company and second on the level of the shareholder. This approach is common for most company setups.
We already mentioned the fact that you pay taxes twice doesn’t necessary mean that you’ll pay more taxes than with pass-through taxation.
The reason for this is that the company pays corporate tax which is mostly a fixed rate. Furthermore, most countries also have a separate tax rate for dividends which is lower than the general income tax rates for professional income.
Moreover, pass-through taxation mostly means you pay social contributions on the full income. On dividends you normally don’t pay any social contributions.
Therefore, if you need to make a comparison between the following taxes you pay in each situation.
In the case of pass-through taxation you’ll need to have a look at the personal income taxes you pay and add any social contributions to this. For double taxation you have a look at the sum of the corporate income tax and the dividend tax.
How to Choose the Right Tax Structure for Your Business
Pass-through taxation vs double taxation is one of the topics you need to understand if you are looking at your tax structure as a digital nomad.
You’ll in any case want to have an understanding of all the tax consequences of the setup before implementing it to avoid any unwanted tax consequences. You wouldn’t the first person who reaches out to me who went for a certain tax setup – the US LLC being a common example – to only find out later it actually doesn’t work for them.
Nevertheless, this is only part of the story. There are many more elements you need to take into consideration to make sure you have a robust tax setup tailored to your international lifestyle.
Luckily, you can find all the information to make an informed decision in the Tax Masterclass for Digital Nomads.
There you learn about all the important concepts in international taxation and how these apply to digital nomads. Furthermore, you get an insight in some popular setups for digital nomads as well as access to country guides for popular nomad destinations and countries where you can optimize your taxes.
