Pass-Through Entity Example: LLCs, Partnerships, and S Corporations

Businesses are taxed in different ways, and one common structure is the pass-through entity. Instead of the business paying income taxes itself, profits and losses pass directly to the owners, who report them on their personal tax returns. This avoids double taxation, where corporations pay taxes on earnings and shareholders pay taxes again on dividends.

Pass-through entities include single-member LLCs, partnerships, and S corporations. Each has distinct tax rules and ownership requirements, making them suitable for different business needs. Choosing the right structure can improve tax efficiency and liability protection.

Single-Member LLC Example

A single-member LLC is popular among freelancers, consultants, and small business owners seeking liability protection without corporate complexity. Since it has one owner, the IRS treats it as a disregarded entity by default, meaning income and expenses are reported on the owner’s personal tax return using Schedule C of Form 1040. This simplifies filing while allowing deductions for business expenses like office supplies, travel, and equipment depreciation.

For example, if a graphic designer operating as a single-member LLC earns $80,000 in revenue and deducts $20,000 in business expenses, only the remaining $60,000 is taxable. However, LLC earnings are considered self-employment income, requiring the owner to pay self-employment tax, which covers Social Security and Medicare. In 2024, the self-employment tax rate is 15.3% on net earnings up to $168,600, with a 2.9% Medicare tax beyond that threshold. To offset this, the owner can deduct half of the self-employment tax when calculating adjusted gross income.

A single-member LLC can elect S corporation tax treatment to reduce self-employment taxes. By paying themselves a reasonable salary and taking additional profits as distributions, the owner avoids payroll taxes on the distribution portion. However, the IRS monitors salary levels to prevent underpayment of employment taxes.

Partnership Example

A partnership is a business structure where two or more individuals share ownership, profits, and responsibilities. Instead of paying taxes at the entity level, income, deductions, and credits flow through to the partners, who report their share on their personal tax returns. The partnership agreement determines how profits and losses are allocated, offering flexibility based on investment, effort, or expertise.

For example, a law firm structured as a general partnership between two attorneys might generate $500,000 in net income. If they split profits equally, each partner reports $250,000 as taxable income. This income is subject to federal and state taxes, as well as self-employment tax, since partners are not considered employees. Unlike wages, partnership earnings are not subject to automatic payroll tax withholding, so partners must make estimated tax payments throughout the year.

Some partnerships allocate income based on capital contributions or workload. A real estate investment partnership, for instance, might have one partner contributing $1 million in capital while another manages property acquisitions. If the agreement grants the investor a 70% share of profits and the manager 30%, those percentages dictate how taxable income is distributed. This flexibility allows partnerships to structure financial arrangements that align with business goals and individual contributions.

S Corporation Example

An S corporation combines the liability protection of a corporation with the tax benefits of a pass-through entity. Unlike traditional corporations, which are taxed separately from their owners, an S corp allows income and losses to be reported on shareholders’ personal tax returns, avoiding corporate-level taxation.

To qualify for S corporation status, a business must meet IRS requirements, including having no more than 100 shareholders, all of whom must be U.S. citizens or residents. It must also issue only one class of stock, meaning all shareholders receive distributions proportional to their ownership percentage. These restrictions prevent large, publicly traded companies from electing S corp status while ensuring a simple ownership structure.

A key advantage of an S corporation is the ability to reduce payroll tax liability. Shareholders who actively work in the business must take a reasonable salary, which is subject to payroll taxes, but any remaining profits can be distributed as dividends, which are not subject to self-employment tax. For example, if a marketing agency structured as an S corporation earns $300,000 in profit and its sole owner takes a $100,000 salary, only that salary is subject to Social Security and Medicare taxes, while the remaining $200,000 is distributed as dividends, avoiding additional payroll taxes. The IRS monitors salary levels to prevent abuse, and underpaying oneself can lead to audits and penalties.