Passthrough income
What Is Pass Through Income and How Does It Work?
In this post, We will talk about passthrough income. This tax technique allows certain business income to avoid direct taxation at the entity level and instead be taxed in the hands of the recipients. We’ll look at how it works, the types of organizations that qualify, and the tax laws, which include key provisions from the Indian Income Tax Act.
Let us look at these sections:
What Is Passthrough Income?
Passthrough income refers to business profits that are distributed directly to owners or shareholders without the business paying taxes. Instead, receivers of this income must pay taxes on their portion. This tax system enables certain types of businesses to avoid direct taxation, moving the burden to the persons who get the profits.
Entities That Generate Passthrough Income
Not all businesses qualify for passthrough income. The most common categories that qualify are:
- Sole proprietorships
- Partnerships
- S-Corporations
- Limited Liability Companies (LLCs)
These businesses are sometimes limited to a single owner or a small group of investors. Every tax year, they distribute profits and losses directly to their shareholders.
Who Pays Taxes on Pass-Through Income?
When a Passthrough business transfers income to its shareholders or partners, the beneficiaries must pay taxes on those earnings. Typically, such payments are considered regular income for tax purposes.
For example, suppose two siblings who are equal business partners. The partnership is required to submit a tax return, but it does not pay taxes. Instead, each sibling pays taxes on their share of the business’s income.
How Is Pass-Through Income Taxed?
Pass-through income is taxed as ordinary income, which is subject to the highest tax bands, ranging from 10% to 37% in 2022, depending on your filing status and income.
High-income earners may be subject to an extra 3.8% net investment income tax on unearned income, which includes some pass-through profits. This can increase your overall tax burden and raise your adjusted gross income, perhaps triggering further taxes on other income streams.
Taxation of Pass Through Income under Sections 115UA and 115UB
Sections 115UA and 115UB of the Indian Income Tax Act address the taxation of pass-through income for business trusts and investment funds. These provisions ensure the income received by certain trusts or funds is taxed directly in the hands of their investors, preventing double taxation at both the entity and investor levels.
Business Trusts
Business trusts, such as Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs), manage income-producing assets. Under Section 115UA, their revenue is taxed in the hands of unit holders, in line with the pass-through principle.
Investment Funds
Investment funds, particularly Alternative Investment Funds (AIFs), pool capital from multiple investors and invest it in a variety of assets. Section 115UB requires that revenue from certain categories of these funds be taxed directly in the hands of investors, ensuring tax transparency.
We have finished this post on Passthrough income. Please leave any questions or comments in the section below, and we’ll be happy to assist.
