What is a Pass-Through Entity?

If you’re starting a business or restructuring an existing one, you’ve likely heard the term “pass-through entity.” But what does it actually mean, and how does it affect your business taxes and structure?

In this blog post, we’ll break down what a pass-through entity is, the types of business structures that qualify, their tax implications, and the pros and cons to help you determine whether it’s the right choice for your situation.

 What Is a Pass-Through Entity?

A pass-through entity is a business structure where the income, deductions, and credits “pass through” the business directly to the owners or investors. The business itself does not pay federal income tax at the entity level. Instead, the owners report their share of the income or loss on their individual tax returns.

This structure helps avoid double taxation, which occurs in traditional corporations (C-Corps) where the business pays corporate income tax, and shareholders are taxed again on dividends they receive.While pass-through entities are exempt from federal entity-level taxation, many states—including California, New York, and New Jersey—impose taxes, fees, or minimum franchise taxes on these entities, meaning that some level of state tax may still apply.

Types of Pass-Through Entities

Several business structures are considered pass-through entities:

1. Sole Proprietorship

• Simplest form of business.
  
• Not a separate legal entity.
  
• Income is reported on Schedule C of the owner’s personal return (Form 1040).
  

2. Partnership

• Owned by two or more individuals.
  
• Must file Form 1065, but profits/losses are reported via Schedule K-1 to each partner.
  
• Each partner includes their share of income on their own 1040.
  

3. Limited Liability Company (LLC)

• By default, a single-member LLC is taxed as a sole proprietorship.
  
• A multi-member LLC is taxed as a partnership.
  
• However, LLCs can elect to be taxed as S-Corps or C-Corps.
  

4. S-Corporation

• Must meet certain IRS criteria (limited shareholders, U.S. citizens/residents, one class of stock).
  
• Files Form 1120S, and issues Schedule K-1 to shareholders.
  
• Passes income, losses, and other tax items to shareholders.
  

Note: A C-Corporation is not a pass-through entity—it pays corporate taxes separately.

How Taxation Works for Pass-Through Entities

Here’s how it works in practice:

1. The business calculates its net income or loss.
   
2. That amount is allocated to the owners based on ownership percentage (or per agreement).
   
3. Each owner reports their share of income/loss on their personal tax return, even if the business doesn’t distribute the income.
   

For example, if a two-person LLC earns $100,000 in profit and the owners split it 50/50, each reports $50,000 on their individual tax return.

Advantages of Pass-Through Entities

• Avoid Double Taxation: Profits are only taxed once—on the owner’s return.
  
• Simplicity: Generally fewer administrative burdens than a C-Corp.
  
• Loss Deduction: Owners may be able to deduct business losses on their personal return (subject to basis, at-risk, and passive activity rules).
  

Qualified Business Income (QBI) Deduction: Many pass-through owners are eligible for up to a 20% deduction on business income (IRC §199A).

Disadvantages of Pass-Through Entities

• Self-Employment Tax: Sole proprietors and partners must pay self-employment tax (15.3% on net earnings) on their share of business income. S-Corporation shareholders do not pay self-employment tax on their share of business income.
  
• Limited Fringe Benefits: S-Corp shareholder-employees owning more than 2% have limitations on tax-free fringe benefits. S-Corp shareholder-employees who meet the 2% threshold must include the value of certain benefits in their taxable income, even if other employees receive them tax-free. Some examples of these include: health insurance premiums and group term life insurance.
  
• Complex Allocations: Partnerships and S-Corps may require more complex accounting for ownership changes or distributions.
  
• Complexity with Multiple Owners: In partnerships and S-Corps, income and deductions must be allocated based on ownership or special allocations. Requires careful tracking, partnership agreements, and Schedule K-1s for each partner/shareholder. Can lead to disputes and compliance complexity.

• State Taxes: Some states impose entity-level taxes or require special elections.
• Taxation of retained earnings: Profits in pass-through entities are taxed whether or not they are distributed.
• At-Risk and Passive Activity Limitations: Losses from a pass-through entity may be limited by at-risk and passive activity limitations.

Less Prestigious in Investor or IPO Scenarios: Pass-through structures are less commonly used for companies aiming to go public or raise venture capital, which often require C-Corp treatment for equity planning and investor preferences.

Pass-Through vs. Double Taxation (Illustration)

Final Thoughts: Is a Pass-Through Entity Right for You?

Pass-through entities offer a tax-efficient and flexible structure, especially appealing for small to mid-sized business owners. However, choosing the right entity type depends on your business goals, income level, risk profile, and long-term vision.

👉 Tip: Always consult with a qualified CPA before finalizing your entity structure to ensure it aligns with both your tax and legal needs.