Pass-through taxation is a tax structure where the owners or shareholders of a business receive its profits and losses and report them on their own tax returns. The business entity itself doesn’t pay federal income tax, which avoids double taxation at a corporate level.
The pass-through tax structure has advantages and disadvantages. This guide covers both so you can decide if pass-through taxation is the right choice for your business. It’s part of the LLC taxes series.
Thinking about opening an LLC? Pass-through taxation is a key concept for all business owners, whether or not you plan to open an LLC.
Pass-through taxation at a glance
| Business type | Business files | Owners report income on |
|---|---|---|
| Sole proprietorship | No separate return | Schedule C with Form 1040 |
| Single-member LLC (default) | No separate income tax return | Schedule C with Form 1040 |
| Partnership or multi-member LLC (default) | Form 1065 (information return) | Schedule K-1, carried to Schedule E |
| S corporation (or LLC electing S status) | Form 1120-S (information return) | Schedule K-1, carried to Schedule E |
| C corporation (not pass-through) | Form 1120; pays 21% corporate tax | Dividends on Form 1040 |
How does pass-through taxation work?
Pass-through entities, also called flow-through or fiscally transparent entities, don’t pay federal income tax at the business level.
When your business makes a profit, it doesn’t pay federal income tax on it. Instead, the profit is added to your personal income and taxed at your individual rates. Sole proprietors and single-member LLC owners report it on Schedule C. Partners, multi-member LLC members and S corporation shareholders get a Schedule K-1 showing their share and report it on their own returns.
What are pass-through businesses?
Pass-through businesses include several structures, each with its own benefits and setup and running requirements.
Sole proprietorship
Sole proprietorships are the easiest business structure for solo entrepreneurs. Anyone who does business without forming an entity is a sole proprietor by default.
Sole proprietors report their income and expenses on Schedule C, Profit or Loss From Business, attached to their tax return (Form 1040, U.S. Individual Income Tax Return), so there’s no federal corporate tax.
Partnership
A partnership is a business entity with 2 or more owners. A general partnership doesn’t need a state filing, while limited partnerships and LLPs register with the state. Either way, the business doesn’t pay federal income tax.
Instead, the partnership files Form 1065, and each partner pays tax on their share of the taxable income using Schedule K-1, so taxation happens at the individual rather than entity level.
Limited liability company (LLC)
LLC formation requires additional steps compared to a sole proprietorship or partnership. LLC members file articles of organization with their Secretary of State, pay a filing fee, appoint a registered agent, and usually write an operating agreement (kept with your records, not filed). How an LLC pays tax depends on the number of owners and any election it makes.
For example, single-member LLCs are treated as sole proprietorships for tax, with the owner reporting profits and losses on Schedule C attached to their Form 1040.
Multi-member LLCs are taxed like partnerships and file Form 1065. Members receive a Schedule K-1, which they use to report their share of the LLC’s profits.
S corporation
An S corporation is a tax status that lets a corporation, or an LLC that elects it, keep corporate-style liability protection while being taxed as a pass-through entity.
S corporations generally don’t pay federal income tax. They file an information return on Form 1120-S, and shareholders use a Schedule K-1 to report their income on Form 1040.
How are a C corporation and a pass-through business different?
A C corporation pays income tax on its corporate earnings, then distributes taxable dividends to shareholders, who pay personal tax on them, creating double taxation.
A key benefit of a C corporation is that profits left in the business (reinvested) are taxed only at the flat 21% corporate rate until they’re paid out.
What are the benefits of pass-through taxation?
Pass-through taxation offers several benefits; some can affect the amount you can reinvest in your business, and others make life easier come tax time. For an LLC-specific view, see LLC tax benefits.
Pass-through businesses avoid double taxation
Pass-through taxation simplifies the tax process by removing federal corporate tax. Instead, you report your share of the business’s profits or losses on your own tax return, which streamlines compliance.
Pass-through businesses can claim tax deductions
Pass-through business owners can take several deductions that lower their overall tax liability.
The main one is often the qualified business income deduction (QBI), which lets eligible owners deduct up to 20% of their qualified business income from their taxable income. The 2025 tax law made it permanent.
To find out whether your business qualifies for the deductions below, speak with a tax accountant or attorney.
- The Section 199A deduction, known as the qualified business income (QBI) deduction, worth up to 20% of qualified business income
- Contributions to retirement plans such as a 401(k), SEP or individual retirement arrangement (IRA)
- The cost of self-employed health insurance
- Half of your self-employment tax
Pass-through taxation provides flexibility
Pass-through businesses have flexible ownership structures and fewer regulatory requirements than corporations, so you can customize arrangements like profit sharing and ownership.
Another pass-through benefit is that you can change your business structure as your brand grows. Here are some common moves.
- Partnerships and sole proprietors can become LLCs and get limited liability by filing articles of organization with their Secretary of State’s office.
- LLCs can elect S corporation taxation by filing Form 2553 with the IRS, so profit above a reasonable salary isn’t subject to self-employment tax.
- An LLC can choose to pay tax as a C corporation by submitting Form 8832, Entity Classification Election, to the IRS.
- S corporations can switch to C corporation taxation by revoking the S election with the consent of shareholders holding more than half the shares.
Greater loss deductions
Pass-through owners whose business has a loss can often offset it against other income on their tax returns, subject to IRS limits, reducing their overall tax liability.
Ease of formation and operation
Pass-through entities have simpler formation and operating requirements than corporations.
Pass-through taxation disadvantages
Self-employment taxes
Owners of sole proprietorships, partnerships and default LLCs usually pay 15.3% self-employment tax on their net earnings, on top of income tax. S corporation shareholders who work in the business pay payroll taxes only on a reasonable salary, and the rest of their share of profit isn’t subject to those taxes.
Tax on earnings you keep in the business
Pass-through owners pay tax on their full share of the profit, even the part they leave in the business. Unlike a C corporation, a pass-through business can’t keep profit at a lower corporate rate, which can make reinvesting earnings more expensive.
Limited deductions for specific industries
Owners of some professional service businesses, such as law, health and consulting, lose the QBI deduction once their taxable income passes an annual threshold. The IRS adjusts the threshold for inflation each year.
Limits on raising capital
S corporations can have no more than 100 shareholders, only one class of stock, and generally only U.S. individual shareholders, which can put off investors.
LLCs and partnerships can sell ownership interests to raise funds, but many venture investors prefer C corporations.
What other taxes do pass-throughs have to remit and pay?
To remit a tax means you collect it on behalf of the government and pass it on, so you only pay over what you collect.
Payable taxes are those due on your business profits and vary depending on your location and income. As a pass-through business owner, you may need to handle several other taxes.
Sales tax
Sellers of taxable products and services usually must collect and remit sales tax at their state’s rates.
You don’t pay sales tax out of your income. Instead, it’s a percentage of your customer’s total bill. You collect it at the point of sale and then remit it to the state.
Business income
Pass-through taxation means the tax on your business income passes through to you and is paid on your own return at your tax rate.
Self-employment and payroll taxes
Pass-through business owners pay self-employment taxes, which cover Social Security and Medicare, based on their net earnings.
Businesses with employees must also withhold Social Security, Medicare, and federal income taxes from wages, pay the employer’s share, and remit them to the IRS.
State and local taxes
Depending on your business’s location, your pass-through business might be subject to state and local taxes such as sales, property, excise, or franchise tax. Many states also let pass-through businesses elect to pay state income tax at the entity level, which can help owners with the federal cap on state and local tax deductions.
Estimated taxes
Most pass-through owners must make estimated quarterly tax payments if they expect to owe $1,000 or more for the year.
Next steps
Tax benefits of pass-through taxation are just one of the factors to consider when choosing a business structure. Others include ease of formation, paperwork, running costs, liability protection, and the ability to raise funds.
Fortunately, pass-through businesses are flexible. You could start as a sole proprietorship or general partnership and form an LLC as your brand grows. Once the business is profitable, compare how to pay yourself under each tax status.
For most small business owners, pass-through taxation makes life easier.
FAQ
Pass-through entities include sole proprietorships, general and limited partnerships, LLPs, LLCs taxed by default, and S corporations. C corporations are not pass-through entities.
It means a pass-through business’s losses flow to the owners, who can often deduct them against other income on their own tax returns, subject to IRS loss limits.
It depends on profit and plans. Many profitable small businesses choose an LLC with an S corporation election, which avoids corporate tax and limits self-employment tax to a reasonable salary.
For most small businesses, yes. It avoids double taxation and allows the QBI deduction. Owners do pay self-employment tax and owe tax on profits they leave in the business.
The LLC doesn’t pay federal income tax. Its profits pass through to the members, who pay tax on their shares on their own returns, while keeping the LLC’s limited liability protection.
Profits are taxed once, on the owners’ returns, instead of at both the business and owner level. Owners may also qualify for the 20% QBI deduction.
A two-person partnership earns $100,000 in profit. The business pays no income tax on it. Each partner reports their share, such as $50,000, on their own return and pays tax at their own rates.