Ordinary Income vs. Distributions: What’s Really Being Taxed in Pass-Through Entities.

Many business owners are familiar with the idea of ‘ordinary income’ and ‘distributions,’ but these two concepts have very different implications when it comes to taxes. If you’re part of a partnership, S-Corporations, or LLC, understanding the difference between what is taxed as ordinary income versus what is distributed can help you navigate your taxes more effectively. In this post, we’ll break it down so you can understand exactly how your taxes are affected by your share of the business’s income and what that means for your distributions.

What is "Ordinary Income”?

In a partnership, S-Corporation, or LLC, the business itself doesn’t pay taxes on its earnings (unless it’s taxed as a corporation). Instead, the income "passes through" to the individual partners, who report it on their personal tax returns. The term ordinary income refers to the share of the business's income that is allocated to you based on your ownership percentage, and you must pay taxes on it, whether or not you actually receive a distribution.

For example, if the business made $100,000 in income, your portion of that income would be taxed at your personal income tax rate.

One of the most important concepts for business owners in partnerships, S-Corporations, and LLCs is pass-through taxation. This means that the business entity itself does not pay taxes directly. Instead, the income generated by the business is "passed through" to the individual owners or shareholders. You report your allocated share of the business income on your personal tax return, regardless of whether you received any cash or property from the business that year.

This system avoids double taxation, which is a feature of traditional corporations. In a C-corporation, for example, the business pays taxes on its income, and then shareholders pay taxes again on any dividends they receive. In contrast, pass-through entities like partnerships, LLCs, and S-corporations avoid this second layer of taxation.

How Distributions Work

A distribution is the money or property that you actually receive from the business. However, just because the business generates ordinary income doesn’t mean you immediately receive a distribution. Even if the business only distributes a portion of its earnings, you will still owe taxes on your allocated share of the ordinary income. For instance, if the business made $100,000 in ordinary income but only distributed $50,000, you would still be taxed on the full $100,000 (if you were allocated that share), regardless of the actual amount you received.

State Taxes: How Do They Affect You?

State tax laws vary, but most states follow the federal pass-through taxation model. This means that, like the IRS, states generally tax your share of business income, even if that income isn't distributed to you. Each state has its own tax rates and rules, so your tax liability could vary significantly depending on where your business is located and where you, the partner, live.

Some states also have specific taxes that apply to pass-through entities, such as a franchise tax, gross receipts tax, or an entity-level income tax. These taxes are typically passed down to the individual partners in the form of additional taxes on their share of income. So, even if you don’t live in the state where the business operates, you may still owe taxes to that state based on the business's activity there.

For example, California imposes a state-level income tax on S-corporations, LLCs, and partnerships, which means that even if you don’t take a distribution, you might be required to pay state taxes on your share of the business income. Other states, such as Texas or Florida, don’t have state income taxes, so you won’t face that same level of taxation.

Who Does This Apply To?

Partnerships, LLCs, and S-corporations all follow this structure. The owners or shareholders of these entities report their portion of ordinary income and pay taxes on it—even if they don’t receive all or any of it as a distribution in the same year. This system avoids the "double taxation" that traditional corporations face by passing income directly to the individual owners for tax purposes.

Understanding the difference between ordinary income and distributions, as well as how pass-through taxation works with both federal and state taxes, is essential for managing your tax obligations effectively. If you need help with how this applies to your business or personal situation, reach out to us at info@mkhstaxgroup.com.