A pass-through entity is a business structure that doesn’t pay federal income tax itself. Instead, all profits and losses “pass through” to the owners, who report that income on their personal tax returns. Most U.S. businesses are structured this way, including sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations.
How Pass-Through Taxation Works
The central idea is straightforward: the business earns income, but the business itself owes no federal income tax. Each owner receives their allocated share of the profits (or losses), and that amount gets added to whatever other income they earned that year, like wages from a job or investment returns. They then pay tax on the total at their individual income tax rate.
This is the opposite of how a C corporation works. A C corporation pays its own federal income tax on profits at a flat 21% rate. Then, when the company distributes those after-tax profits to shareholders as dividends, the shareholders pay tax again on the money they receive. This “double taxation” is the key disadvantage that pass-through structures avoid.
With a pass-through entity, distributions to owners are generally tax-free, depending on the owner’s basis in the entity. Basis is essentially the amount of money or property you’ve invested in the business, adjusted over time for profits, losses, and withdrawals. As long as you’re not pulling out more than your basis, distributions don’t trigger additional tax because you’ve already paid tax on the income as it was earned.
Types of Pass-Through Entities
Four main business structures qualify as pass-throughs, and each works a bit differently.
- Sole proprietorships are the simplest form. If you freelance, do contract work, or run a one-person business without forming a separate legal entity, you’re a sole proprietor by default. You report business income and expenses on Schedule C of your personal tax return.
- Partnerships exist when two or more people co-own a business. The partnership itself files an informational tax return (Form 1065) with the IRS, but it pays no tax. Each partner receives a Schedule K-1 showing their share of income, deductions, and credits, which they then report on their personal return.
- LLCs (limited liability companies) are flexible. A single-member LLC is taxed like a sole proprietorship unless it elects otherwise. A multi-member LLC is taxed like a partnership. Some LLCs elect to be taxed as S corporations for potential payroll tax savings. The LLC itself is a legal structure, not a tax classification, which is why it can be treated different ways.
- S corporations file Form 1120-S with the IRS and issue Schedule K-1s to shareholders, similar to partnerships. To qualify, a business must meet specific requirements: no more than 100 shareholders, only one class of stock, and all shareholders must be U.S. citizens or residents. S corporation owners who work in the business must pay themselves a reasonable salary, which is subject to payroll taxes, but additional profit distributions avoid those payroll taxes.
The Schedule K-1
If you own a share of a partnership, S corporation, or multi-member LLC, you’ll receive a Schedule K-1 each year. This form breaks down your portion of the business’s income, losses, deductions, and credits. You use it to fill out your personal tax return. The business sends a copy to the IRS as well, so the numbers need to match.
K-1s are notorious for arriving late, often well into March or April, because the business’s return has to be completed first. This can delay your personal filing. If you’re a partner or S corp shareholder, plan accordingly.
The 20% Qualified Business Income Deduction
The Tax Cuts and Jobs Act of 2017 created a significant tax break for pass-through owners called the Qualified Business Income (QBI) deduction under Section 199A. It allows eligible taxpayers to deduct up to 20% of their qualified business income from a pass-through entity, effectively lowering the tax rate on that income. You can claim it whether you itemize deductions or take the standard deduction.
The deduction has limitations. Above certain income thresholds, the deduction may be reduced or eliminated depending on the type of business you operate, the W-2 wages the business pays, and the value of physical assets (like equipment or property) the business holds. Service-based businesses such as law firms, medical practices, and consulting firms face the tightest restrictions at higher income levels. Income earned as a W-2 employee or through a C corporation doesn’t qualify.
This deduction is scheduled to expire at the end of 2025 unless Congress extends it. If it sunsets, pass-through business owners would lose the 20% deduction starting with the 2026 tax year, which could meaningfully increase their effective tax rate.
How Losses Work
One practical advantage of pass-through entities is that business losses also flow to the owners. If the business loses money in a given year, you can generally use your share of that loss to offset other income on your personal return, like wages or investment gains. This can lower your overall tax bill.
There are limits, though. You can only deduct losses up to the amount of your basis in the business. S corporations have additional “at-risk” rules that further restrict how much loss you can claim. And an excess business loss above a certain annual threshold gets carried forward to future years rather than used all at once. By contrast, C corporations can carry forward losses but are limited to offsetting only 80% of future income.
Self-Employment Tax Considerations
Pass-through income isn’t just subject to income tax. Depending on the structure, it may also be subject to self-employment tax, which covers Social Security and Medicare. Sole proprietors and general partners in a partnership pay self-employment tax on their share of business earnings at a combined rate of 15.3% (12.4% for Social Security up to the annual wage base, plus 2.9% for Medicare).
S corporation owners can reduce this burden. Only the salary they pay themselves is subject to payroll taxes. Profit distributions above that salary are not. This is one of the main reasons business owners elect S corporation status, though the IRS requires the salary to be “reasonable” for the work performed. Setting your salary artificially low to dodge payroll taxes is a common audit trigger.
When a C Corporation Might Be Better
Pass-through taxation isn’t automatically the best choice. A C corporation’s flat 21% tax rate can be lower than the top individual rates that high-earning pass-through owners pay. If the business plans to reinvest most of its profits rather than distribute them to owners, a C corporation may result in less tax in the near term since the money stays inside the company and isn’t taxed again until it’s distributed.
C corporations also benefit from Section 1202, which can exclude up to 100% of capital gains when selling qualified small business stock held for more than five years. For founders planning a long-term exit, this exclusion can be worth millions in tax savings, something pass-through structures don’t offer.
The right structure depends on how much income the business generates, whether owners need regular distributions, how many owners are involved, and the long-term plan for the company. Many businesses start as pass-throughs for simplicity and convert later if circumstances change.