Pass-Through Taxation

Pass-through taxation is a tax structure in which a business's profits and losses flow directly to the owners' personal tax returns rather than being taxed at the entity level. The business itself pays no federal income tax. Instead, each owner reports their allocated share of income and pays tax at their individual rate. The business may still need to file an information return, pay payroll taxes, collect sales tax, or pay state-level entity taxes, depending on its structure and location.

The Internal Revenue Service (IRS) allows the following entities to use pass-through taxation:

• Sole proprietorships
• Partnerships
• S corporations
• LLCs

While pass-through taxation simplifies the tax process for many qualifying small businesses, owners may face higher individual tax rates if business income pushes them into a higher tax bracket. Additionally, self-employed individuals typically pay both the employer and employee portions of their Social Security and Medicare taxes. For this reason, owners of pass-through entities may be subject to self-employment taxes on their share of business profits.

For a better understanding of how this system of taxation could impact your business, read this article on the benefits of pass-through taxation.

How it works

The business calculates its income, deductions, gains, losses, and credits for the year. Those tax items then pass through to the owner or owners. Each owner receives a proportional share of income, deductions, credits, and losses, which they report on their personal federal return.

Partnerships generally file Form 1065 and issue Schedule K-1 to partners. S corporations generally file Form 1120-S and issue Schedule K-1 to shareholders. Sole proprietors usually report business income and expenses directly on Schedule C with Form 1040.

Key characteristics

Pass-through taxation affects how owners report income, losses, and taxes:

• Single layer of tax. Income is taxed only at the owner level.
• Personal rates apply. Owners usually pay tax on pass-through income at their individual federal income tax rates. State tax treatment varies.
• Loss deductibility. Owners may be able to deduct pass-through losses, but basis, at-risk, passive activity, and excess business loss rules can limit those deductions.
• QBI deduction. Under the Tax Cuts and Jobs Act of 2017, made permanent in July 2025, eligible pass-through owners may deduct up to 20% of qualified business income, subject to income thresholds and industry limitations.

Limitations to consider

Pass-through taxation doesn’t work the same way for every business owner. Owners owe income tax on their allocated share of profits even if the business retains the cash rather than distributing it, a situation known as phantom income.

Self-employment and payroll taxes also matter. Sole proprietors and some partners may owe self-employment tax on net earnings from self-employment. S corporation shareholder-employees who perform services for the business generally must receive reasonable compensation subject to employment taxes before taking distributions.

State tax treatment varies. Some states impose taxes on pass-through entities or offer special tax elections, so owners should review their state’s rules or consult a tax professional.

Related terms

• Franchise tax: A state-level tax imposed on certain business entities that may also apply to pass-through entities in some states.
• Profit allocation: The process by which a partnership or LLC distributes income and losses among owners, directly affecting each owner's pass-through tax liability.
• Schedule K-1: Schedule K-1 reports an owner’s share of income, deductions, credits, and other tax items from a partnership, S corporation, trust, or estate.
• S corporation: An S corporation is a corporation that elects pass-through federal income tax treatment if it meets IRS eligibility rules.

FAQs about pass-through taxation

Can a pass-through owner be taxed on income they never received?

Yes. If a partnership or S corporation earns a profit but retains the cash, each owner still owes income tax on their allocated share as shown on their Schedule K-1, regardless of whether any money was distributed.

How does an S corporation differ from a sole proprietorship for tax purposes?

A sole proprietor generally reports business income on Schedule C and may owe self-employment tax on net earnings. An S corporation generally files Form 1120-S, passes income or loss through to shareholders, and must pay reasonable compensation to shareholder-employees who perform services for the business. Distributions may receive different tax treatment than wages, but the IRS can reclassify payments if the shareholder-employee is not paid reasonable compensation.

When does a C corporation make more sense than a pass-through entity?

Businesses seeking venture capital, institutional investment, or multiple classes of stock often find C corporation status more practical, since pass-through entities like S corporations face strict restrictions on the number and types of shareholders. Corporate taxation may also benefit businesses that plan to retain most of their earnings rather than distribute them to owners.