What Is a Pass-Through Entity?

A pass-through entity refers to a business that does not pay income tax of its own. Its income, losses, credits, and deductions “pass-through” to each business owner’s personal tax return, where the company’s profits are taxed according to each owner’s individual income tax rate.

Business structures treated as pass-through entities include:

• Sole Proprietorships
• General Partnerships
• Limited Partnerships
• Limited Liability Partnerships
• Limited Liability Companies (LLCs) – Unless an LLC elects to be taxed as a Corporation
• S Corporations

Many entrepreneurs start their companies as pass-through business structures for various reasons, including their relative ease of filing taxes compared to C Corporations.

How Do Pass-Through Entity Business Owners Get Paid?

Generally, with Sole Proprietorships, LLCs, and Partnerships, owners cannot be considered employees of their company, nor can they receive compensation in the form of wages and salaries. Instead, they get paid via “owner’s draws.” An owner’s draw means they take money out of their share of the company’s profits—usually either by writing themselves a business check or transferring funds (if the bank allows it) from the business to their personal account. An exception is LLCs that elect S Corporation tax treatment. S Corps must put shareholders who work in the business on payroll and pay them a reasonable wage or salary for the work they perform. An S Corporation’s shareholders may also receive profit distributions from their company according to the provisions of their governing documents.

Pass-Through Entity Tax Treatment

Federal Income Tax

Pass-through entities do not pay federal income tax at the corporate tax rate; instead, taxes flow through to each business owner’s individual tax returns. Therefore, business profits are subject to the individual owner’s personal tax rate rather than the corporate tax rate.

Will that be advantageous from an overall financial standpoint?

It depends. If the owners’ individual federal income tax rates are lower than the corporate tax rate, this might result in less tax. However, many factors can come into play, including state income tax rates and other tax laws where a business is located. For that reason, I recommend enlisting the expertise of an accountant or tax professional who can assess the situation and offer insight.

Here’s some general information about how federal income taxes are handled for various pass-through entity types:

• Sole Proprietorship – A business and its owner are not separate tax-paying entities. The income tax filing for a Sole Proprietorship gets calculated on Schedule C of the owner’s personal tax return, with the net income or loss passed through to Schedule 1 of IRS Form 1040.
• Single-Member LLC – Income tax for an LLC with one owner (or one jointly owned by spouses) is handled the same way as a Sole Proprietorship. Business income and losses flow through to the owner’s personal income tax return (Form 1040).
• Partnership – The business’s income or loss is divided among the owners (partners) according to their distributive share percentage described in the company’s partnership agreement. The Partnership reports its income and losses on a partnership return (IRS Form 1065), but the company does not pay income tax directly—and it must send each partner a Schedule K-1 that shows the individual’s share of the business profits. Each partner must then include that information on Schedule E of their personal tax return and pay tax on profits at their individual tax rate.
• Multi-Member LLC – The IRS treats Multi-member LLCs the same as Partnerships. The LLC files Form 1065 with the IRS and sends each business owner (member) a Schedule K-1 to report their share of the business’s profits. Each owner must report their Schedule K-1 information in Schedule E of Form 1040.
• S Corporation – The S Corporation is not a type of business entity but rather a special tax election that eligible LLCs and C Corporations may request from the IRS. An S Corporation’s income taxes pass through to its owners (shareholders), but tax filing requirements depend on the underlying business entity.

Usually, business owners must report and pay federal income tax quarterly via estimated tax payments online using the IRS’s Electronic Federal Tax Payment System (EFTPS) or completing and mailing Form 1040-ES, Estimated Tax for Individuals.

State and Local Income Tax

States and municipalities generally handle income tax on pass-through entities similarly to the federal government. Business owners report and pay income tax as individuals on their company’s income and losses, using the state and local tax electronic payment portals or preparing and sending the appropriate paper returns. However, in addition to the owners reporting the income and losses on their individual tax returns, some states have a franchise or gross receipts tax at the entity level.

Self-Employment Taxes

The owners of most pass-through entities are subject to self-employment taxes (Social Security and Medicare) under SECA (the Self-Employment Contributions Act of 1954) because they are not considered employees of their companies and, therefore, do not have any portion of those taxes withheld from their pay. Self-employed individuals must pay the entire 12.4% Social Security tax and 2.9% Medicare tax, which totals 15.3%, to the federal government. Typically, they must estimate their tax due and pay it in quarterly installments as part of their quarterly estimated income tax payments.

People employed by other businesses must contribute to Social Security and Medicare, too. But it’s handled differently for employed individuals, with half of those taxes paid by the employer while the other half are withheld (as FICA) from employees’ paychecks. Employers then remit the withheld FICA dollars and their share of employees’ Social Security and Medicare taxes to the federal government.

S Corporations and Self-Employment Tax

The S Corporation is the one pass-through entity that relieves business owners from paying the entire self-employment tax burden. An S Corp’s shareholders who work in the business are on payroll as employees, so they only pay Social Security and Medicare taxes on their wages and salaries, not all of the business’s profits. The individuals’ employee income from their wages or salary is subject to half of the Social Security and Medicare taxes due, which is withheld from their paychecks. The S Corp pays the other half of those taxes. The remaining business profits paid as distributions to the S Corporation owners are subject to income tax but not self-employment taxes. Be aware that entrepreneurs must take care to pay themselves a reasonable salary. If they try to game the system by paying themselves a meager wage and taking most of their compensation via distributions to avoid paying self-employment taxes, the IRS may become suspicious and initiate an audit.

Pass-Through Entity Tax Deduction

The Tax Cuts and Jobs Act (TCJA), passed into law at the end of 2017, created tax reforms that affect pass-through entities through December 31, 2025. Pass-through entities may claim a 20% deduction of their share of Qualified Business Income (QBI) before paying federal income taxes. There are limitations to what can be calculated in the deduction and how much of a deduction is allowed.

Here are some highlights:

• The deduction must be equal to 20% of the QBI earned from the business.
• Not all business income is considered QBI, so the deduction amount may not be as significant as one might hope for.
• If the QBI income reaches a particular threshold, the deduction is restricted to the lesser of 20% of the business’s QBI or the greater of 50% of the total W-2 wages paid by the business or 25% of the total W-2 wages paid by the business plus 2.5% of qualified (depreciable) property.
• The 20% deduction may not apply for businesses where “the principal asset is the reputation or skill of one or more of its employees or owners” if their income reaches a particular threshold. That includes services in the fields of health, law, accounting, performing arts, consulting, athletics, financial services, and others.
• Other limitations apply to pass-through entities other than service providers if their taxable income exceeds specific thresholds.
• Other restrictions and nuances exist, so it is helpful to get professional tax assistance when calculating the deduction and preparing tax forms.

It remains to be seen whether the new Presidential administration will extend the QBI deduction beyond its upcoming expiration date.

Pros and Cons of Operating a Business as a Pass-Through Entity

Could operating a pass-through business or incorporating be the right choice for you? There’s much to consider! Anyone starting a business should carefully research their options and speak with licensed accounting, legal, and tax professionals for expert guidance before deciding on a business entity type. In the meantime, here are some pros and cons of the pass-through structure.

Potential advantages:

• Simple to Form – Sole Proprietorships and General Partnerships (usually) require no entity registration paperwork with the state. These structures are assumed as soon as someone begins conducting business. If business owners wish to operate their company under a name other than one that includes their legal personal name, the state (or county) may require filing a DBA (a.k.a. fictitious name filing). A business with a single owner is by default considered a Sole Proprietorship. A company with multiple owners is by default considered a General Partnership. Other types of partnerships typically require submitting some kind of registration documents with the state, and forming an LLC requires filing Articles of Organization. If an LLC wants to be treated as an S Corp for tax purposes, it must file IRS Form 2553.
• Minimal Business Compliance Formalities – Pass-through businesses generally have less government oversight and fewer ongoing compliance requirements than corporations. C Corporations must appoint a board of directors, have bylaws, and hold annual shareholder and board of directors meetings. They also may have some state reporting requirements that pass-through entities do not. LLCs (including LLCs that choose to be taxed as an S Corporation) have compliance requirements that Sole Proprietorships and Partnerships do not. Some states may require that LLCs hold annual member meetings and record minutes from those events. Although states typically don’t demand member meetings, an LLC must hold them and record minutes if their LLC operating agreement requires it. Note that all pass-through entities must obtain all licenses and permits (local, state, and federal—depending on the type of business and its location) required to operate legally. They must also report and pay all tax obligations on time and follow any other rules and regulations that apply to them.
• Not Subject to the Double Taxation That C Corporations Face – A C Corporation pays tax on its profits at the corporate rate. Its shareholders also pay personal taxes on any corporate profits they receive as dividends. Those dividends are not tax-deductible for the corporation. Because a C Corporation and its owners both pay tax on that dividend income, it’s referred to as double taxation. Pass-through entities have all income flowing through to their owners. They do not pay tax as a business entity, avoiding the double tax hit corporations undergo.

Potential disadvantages:

• Might Not be Financially Beneficial for the Business’s Owners – Business owners may discover they fall into a higher individual tax bracket with all profits passing through to their individual income tax returns. Depending on the circumstances, this might result in paying more tax overall than they would if they had incorporated the business.
• Could Result in a Heavy Self-Employment Tax Burden – Owners of Sole Proprietorships, Partnerships, and LLCs may find that their self-employment tax burden is prohibitive. Remember, they pay it on all of the business’s profits. In contrast, S Corporation shareholders only pay self-employment taxes on the wages and salaries they get paid.
• Sole Proprietorships and General Partnerships Are Not Protected from Business Liabilities – Sole proprietors and partners are not only the same tax-paying entity as their business but also the same legal entity. With no legal separation between owners and their company, the owners’ personal assets (home, retirement funds, vehicles, etc.) are at risk if someone were to sue the business. However, LPs are not separate legal entities but can provide limited liability protection for limited partners. LLCs and S Corps (and LLPs in some states) are separate legal entities and provide limited liability protection to (all or some of) their owners. Under most circumstances, their owners are personally protected from debts and legal actions against their companies. Alternatively, C Corporations provide the greatest level of personal liability protection for business owners and specific stakeholders.
• May Have a More Difficult Time Attracting Investors – Some investors will only invest in businesses that have incorporated. This may limit pass-through companies’ growth potential as they face challenges getting the funds needed to expand and evolve.

FAQs

Is a flow-through entity the same as a pass-through entity?

Yes, the terms are used interchangeably to refer to a business structure that is not a separate tax-paying entity from its owner(s).

What is the difference between a pass-through entity and an LLC?

The term “pass-through entity” refers to any company whose tax obligations pass through to its owners’ individual tax returns. An LLC is a type of pass-through entity unless it elects to be treated as a corporation for tax purposes.

Is an S Corp a pass-through entity?

Yes! Yes, an S Corporation is a corporation that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes.

If an LLC elects S Corp tax treatment, although the entity remains a pass-through entity, how its business owners get paid and how Social Security and Medicare taxes are handled differ from LLC default tax treatment. When a C Corporation is granted S Corporation election, its default corporate tax treatment no longer applies and all income tax obligations flow through to its shareholders personal returns.

Do businesses with pass-through tax treatment pay less tax?

Whether it results in a lower tax bill depends on several factors. Consulting an accountant or tax professional to assess your situation will help you determine if operating your business as a pass-through entity will make financial sense.

What do I have to do to form a pass-through entity?

It depends. Usually, there are no registration requirements for Sole Proprietorships and General Partnerships, while other forms of partnerships and Limited Liability Companies must file a document with the state. And any business that will not do business under its legal name (in the case of sole proprietors and partnerships, the business name is the same as the owners’ names) must file for a Doing Business As (DBA), also known as a fictitious name.