A pass-through entity is a business that pays no federal income tax of its own. Its profits, losses, deductions, and credits flow directly to the owners, who report them on their personal returns and pay tax at their individual rates. That single layer of tax is the defining feature of pass-through entity taxation, and it is the main reason most small and mid-sized U.S. businesses are organized this way rather than as standard C-Corporations, which pay a 21% corporate tax before shareholders are taxed again on any dividends.
Which Businesses Are Pass-Through Entities
Four common structures are taxed as pass-throughs.
Sole proprietorships. No legal separation exists between you and the business. All income and expenses go on Schedule C of your personal return.1Internal Revenue Service. Schedule C and Schedule SE 1 A single-member LLC that has not elected corporate treatment is taxed the same way, as a “disregarded entity.”2Internal Revenue Service. Single Member Limited Liability Companies
Partnerships. Two or more owners, defaulting to partnership classification. The partnership files Form 1065 as an information return but owes no federal income tax.3Internal Revenue Service. About Form 1065, U.S. Return of Partnership Income A multi-member LLC is taxed as a partnership by default.
S Corporations. Not a separate entity type, but a federal tax election made on Form 2553. To qualify, the business must be a domestic corporation with no more than 100 shareholders, only one class of stock, and only shareholders who are U.S. citizens or residents.4Internal Revenue Service. S Corporations It files Form 1120-S and pays no entity-level federal income tax.5Internal Revenue Service. About Form 1120-S, U.S. Income Tax Return for an S Corporation
LLCs. LLCs pick their federal tax classification. Single-member LLCs default to sole proprietorship treatment, multi-member LLCs to partnership treatment, and either can elect to be taxed as a C-Corporation or S-Corporation by filing the right form.6Internal Revenue Service. LLC Filing as a Corporation or Partnership The election changes only how the IRS treats the business, not its legal status under state law.
How the Income Reaches Your Personal Return
The path from business profit to your 1040 depends on which structure you have.
Sole proprietors and single-member LLCs skip the entity return entirely. Income and expenses land on Schedule C, which feeds Form 1040. There is no separate filing for the business.
Partnerships and S Corporations file their own returns even though they owe no tax. The entity issues each owner a Schedule K-1 breaking out their share of ordinary business income, capital gains, interest, charitable contributions, and other items.7Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065) (2025) Owners carry those K-1 amounts onto their personal returns.
The entity return still has real teeth. Missing the filing deadline for a partnership or S Corporation return triggers a penalty of $255 per owner per month, for up to 12 months.8Internal Revenue Service. Failure to File Penalty A five-owner S Corporation that files three months late owes $3,825 in penalties. This surprises first-time filers who assume “no tax owed” means “no urgency.”
Self-Employment and Payroll Taxes
Pass-through income avoids corporate income tax. It does not avoid Social Security and Medicare tax, and how that liability is calculated depends heavily on entity type.
Sole Proprietors and Partners
Net profit from a sole proprietorship or partnership is generally subject to self-employment tax at a combined 15.3%, split between 12.4% for Social Security and 2.9% for Medicare.9Internal Revenue Service. Topic No. 554, Self-Employment Tax The Social Security portion applies only up to the wage base, which is $184,500 for 2026.10Social Security Administration. Contribution and Benefit Base The 2.9% Medicare piece has no cap.
Higher earners owe an extra 0.9% Additional Medicare Tax on self-employment income above $200,000 for single filers or $250,000 for joint filers.11Internal Revenue Service. Questions and Answers for the Additional Medicare Tax Those thresholds are not indexed for inflation.
S Corporation Shareholders
S Corporations split the owner’s income into two pieces, and this is one of their biggest practical advantages. A shareholder who works in the business must draw a salary that qualifies as “reasonable compensation,” and that salary is subject to standard FICA payroll taxes.12Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers Profit distributed beyond that salary is generally not subject to self-employment or FICA tax, which can produce real savings versus a sole proprietorship or partnership where every dollar of net profit is hit with SE tax.
The IRS watches this closely. Setting the salary artificially low to shrink payroll taxes is one of the most common S Corporation audit triggers, and courts weigh factors like the shareholder’s training, hours worked, comparable market pay, and the company’s dividend history when deciding whether compensation was reasonable.13Internal Revenue Service. Wage Compensation for S Corporation Officers
Quarterly Estimated Tax Payments
Pass-through entities do not withhold income tax the way an employer does from a paycheck, so owners are generally on the hook for making quarterly estimated payments to the IRS. For the 2026 tax year, the payments are due April 15, June 15, and September 15 of 2026, plus January 15, 2027.14Taxpayer Advocate Service. Your Tax To-Do List – Important Tax Dates for 2026
Underpaying triggers a penalty calculated on the shortfall for each quarter. You generally avoid the penalty by paying at least 90% of the current year’s tax or 100% of the prior year’s tax (110% if your adjusted gross income exceeded $150,000).15Internal Revenue Service. Underpayment of Estimated Tax by Individuals Penalty S Corporation shareholders drawing a salary can sometimes cover most of their tax through W-2 withholding. Sole proprietors and partners rarely have that option.
The Qualified Business Income Deduction
The Qualified Business Income deduction, created by the 2017 Tax Cuts and Jobs Act under Section 199A, lets eligible pass-through owners deduct up to 20% of their qualified business income from taxable income.16Internal Revenue Service. Qualified Business Income Deduction It was originally set to expire after December 31, 2025, but the One Big Beautiful Bill Act, signed in July 2025, made it permanent.
QBI is the net income from a U.S. trade or business. It excludes investment items like capital gains and interest, guaranteed payments to partners, and reasonable compensation paid to S Corporation shareholders.17Office of the Law Revision Counsel. 26 U.S. Code 199A – Qualified Business Income The deduction reduces income tax only. It does not reduce self-employment tax.
The full 20% deduction is available when taxable income falls below annually indexed thresholds. For 2026, those thresholds are approximately $191,950 for single filers and $383,900 for joint filers. Above the threshold, two limitations kick in.
The first targets Specified Service Trades or Businesses (SSTBs), which include health care, law, accounting, consulting, and financial services. Above the threshold, the deduction phases out over a set range for SSTB owners and disappears entirely once income clears the top of that range.17Office of the Law Revision Counsel. 26 U.S. Code 199A – Qualified Business Income
The second applies to non-SSTB businesses above the threshold. The deduction cannot exceed the greater of 50% of W-2 wages paid by the business, or 25% of W-2 wages plus 2.5% of the original cost of the business’s tangible depreciable property.17Office of the Law Revision Counsel. 26 U.S. Code 199A – Qualified Business Income A solo consultant with no payroll and minimal equipment sees the deduction shrink fast once income clears the threshold; businesses with wages and capital assets fare much better.
Loss Limits
Using business losses to offset other personal income is a headline advantage of pass-through taxation, but four separate limits apply in sequence.
Basis Limitation
You can only deduct losses up to your tax basis in the entity. For a partner, basis starts with your capital contributions and increases with your share of partnership profits and debt. For an S Corporation shareholder, basis starts with your stock investment plus any direct loans you have made to the corporation; third-party debt the corporation takes on does not increase your basis. Losses above basis are suspended and carried forward.
At-Risk Rules
Even with sufficient basis, losses are further limited to amounts you are personally at risk for. Nonrecourse debt you are not personally liable for generally does not count, with an exception for certain real estate financing.18Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
Passive Activity Rules
Losses from a business in which you do not “materially participate” are passive, and passive losses can only offset passive income, not wages or active business income. The IRS applies seven material-participation tests, the most common being more than 500 hours of work in the activity during the year.18Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules A special exception allows up to $25,000 in rental real estate losses if you actively participated and your modified adjusted gross income is below $100,000.
Excess Business Loss Limitation
After the other limits, a final cap applies. For 2026, non-corporate taxpayers cannot deduct aggregate net business losses exceeding $256,000 (single) or $512,000 (married filing jointly). Losses above those amounts convert to a net operating loss carryforward for the following year. The One Big Beautiful Bill Act made this limitation permanent.
State Pass-Through Entity Taxes
Federal law caps the state and local tax (SALT) deduction on individual returns. Under the One Big Beautiful Bill Act, the cap is $40,000 ($20,000 for married filing separately), with a phasedown for higher-income taxpayers that can drop it as low as $10,000.19Internal Revenue Service. Topic No. 503, Deductible Taxes For pass-through owners in high-tax states, that cap is expensive.
Over 30 states have created a workaround: elective pass-through entity taxes. The partnership or S Corporation elects to pay state income tax at the entity level rather than passing that liability to the owners. Because the business pays the tax, it qualifies as an ordinary business deduction on the federal return, which reduces the income flowing through to owners. The IRS confirmed that these entity-level state tax payments are deductible by the business.20Internal Revenue Service. Notice 2020-75
Owners then receive a credit on their personal state return for the amount the entity already paid, so the same income is not taxed twice at the state level. The net effect is that state tax dollars get treated as a business expense (fully deductible federally) instead of an individual SALT deduction (capped). Rates, eligibility, and mechanics vary by state, so the election is worth evaluating each year against the owners’ income and the state’s specific program.