What Is a Pass-Through Payment & How Does It Work?

A pass-through payment is a financial transaction where funds are received by one party but are intended for, or subsequently transferred to, another party without becoming the primary recipient’s revenue or income. This arrangement highlights an intermediary role, where the initial recipient acts as a temporary holder of funds.

Understanding Pass-Through Payments

A pass-through payment describes funds an entity or individual receives that do not constitute their own revenue or income. These amounts are merely “passing through” to a final recipient. The party initially receiving the payment functions as a conduit or agent, facilitating the movement of money from its source to its intended beneficiary.

The intermediary does not gain beneficial ownership of the funds. Instead, they hold the funds in trust or on behalf of another party. This temporary custody is distinct from receiving direct income.

These payments facilitate transactions, manage funds on behalf of others, or simplify financial flows between multiple parties. For example, a business might collect payment from a customer that includes an amount owed directly to a third-party vendor. The business then sends that specific portion to the vendor.

Unlike a direct payment, where the recipient keeps the funds as their own income, a pass-through payment implies a subsequent transfer. This mechanism streamlines financial operations, particularly in complex arrangements involving multiple stakeholders.

Common Scenarios for Pass-Through Payments

Pass-through payments commonly occur in various business and financial contexts, often simplifying transactions between parties.

Agent-Principal Relationships

One frequent scenario involves agent-principal relationships, such as those seen with real estate agents or talent agents. These agents receive payments directly from clients or customers on behalf of their principals. They then disburse the agreed-upon amounts, less any commissions or fees, to the principal. The full amount received by the agent is a pass-through payment, with only their commission representing their own income.

Escrow Accounts

Escrow accounts are another example, where funds are held by a neutral third party until specific conditions are met. In real estate transactions, a buyer’s deposit is often placed in an escrow account and held by a title company or attorney. These funds remain in escrow until the sale closes, at which point they are released to the seller or used for closing costs. The escrow holder acts purely as a temporary custodian.

Reimbursements and Expense Pass-Throughs

Businesses frequently encounter reimbursements and expense pass-throughs. A common instance is a consulting firm paying for a client’s specific project-related expenses, such as travel costs or software licenses. The firm then bills the client for these exact costs, effectively passing the expense through without marking it up as revenue. This ensures the client bears the direct cost.

Government Grants

Certain government grants operate on a pass-through basis, where a primary recipient organization receives funds with the explicit mandate to distribute portions to sub-recipients. For example, a state agency might receive federal grant money designed to be allocated to local community organizations for specific programs. The state agency acts as an intermediary, ensuring the funds reach the intended local beneficiaries according to grant guidelines.

Online Platforms and Marketplaces

Many online platforms and marketplaces facilitate payments between buyers and sellers, acting as intermediaries. When a customer purchases an item on an e-commerce platform, the platform often collects the payment. A portion of this payment, after deducting service fees, is then passed through to the seller. The platform’s revenue is only its fee, while the bulk of the payment is a pass-through to the product’s vendor.

Pass-Through Entities

Income from certain business structures, known as pass-through entities, also represents a form of pass-through payment from the entity to its owners. Structures like S corporations or partnerships do not pay corporate income tax at the entity level. Instead, the entity’s profits and losses are passed through directly to the owners’ individual tax returns, where they are reported as personal income or loss. This means the entity’s income is effectively paid to the owners for tax purposes.

Accounting Treatment of Pass-Through Payments

Properly accounting for pass-through payments is important for accurate financial reporting. These payments are generally not recognized as revenue by the intermediary. Including pass-through funds as revenue would artificially inflate a company’s top-line figures, distorting metrics such as gross margin and revenue growth. The intermediary’s actual earnings come only from any fees or commissions earned for facilitating the transaction.

When a pass-through payment is received, the funds are recorded on the balance sheet as a liability, rather than an income statement item. For example, upon receipt of the funds, a company would debit its cash account and credit a liability account, such as “Funds Held for Others,” “Client Deposits,” or “Due to Third Parties.” This entry acknowledges that the company has received cash but has a corresponding obligation to transfer it to another party. The liability account reflects the company’s commitment to disburse these funds.

When the pass-through funds are subsequently disbursed to the ultimate recipient, the accounting entry reverses the initial liability. The company would debit the liability account (e.g., “Funds Held for Others”) to reduce the outstanding obligation and credit its cash account to reflect the outflow of funds. This pair of entries ensures that the transaction has no net effect on the company’s income statement and accurately reflects the temporary nature of the funds on the balance sheet. For instance, if $10,000 is received as a pass-through, cash increases by $10,000, and a $10,000 liability is created. When the $10,000 is sent out, cash decreases by $10,000, and the liability is eliminated.

Correctly classifying these funds prevents the distortion of financial ratios that rely on revenue or income figures. If pass-through amounts were mistakenly treated as revenue, a company’s profitability ratios, such as net profit margin, would appear lower than they truly are relative to its actual operating revenue. Similarly, growth rates based on reported revenue would be misleadingly high. Maintaining this clear distinction provides stakeholders with a more transparent view of the company’s operational performance.

It is important to distinguish between a pure pass-through and a direct reimbursement of costs. The accounting treatment hinges on whether the initial expenditure was part of the intermediary’s own operating costs or an outlay made purely on behalf of a third party, with no intention of earning revenue from that specific expenditure.

Tax Implications of Pass-Through Payments

The tax treatment of pass-through payments is distinct for the intermediary versus the ultimate recipient, based on who truly earns the income. From the intermediary’s perspective, the pass-through funds themselves are generally not considered taxable income. Since these funds are merely held temporarily and then transferred, they do not represent a gain or profit to the intermediary. For example, if a real estate agent receives a $300,000 payment for a property sale, but their commission is $9,000, only the $9,000 commission is taxable income to the agent. The remaining $291,000 is a pass-through payment to the seller and is not taxed as income to the agent.

Conversely, the funds become taxable income for the ultimate recipient when they are received or earned by that party. The ultimate recipient is the entity or individual who has beneficial ownership of the funds and for whom the payment represents revenue or compensation for goods or services. For instance, the property seller in the previous example would report the $300,000 (or the net amount after agent fees) as part of their taxable income from the sale of the property. The tax liability shifts to the party who ultimately benefits from the funds.

Intermediaries may have specific reporting obligations to the Internal Revenue Service (IRS) regarding pass-through payments. If the payment is for services performed by the ultimate recipient and exceeds certain thresholds, typically $600 in a calendar year, the intermediary may be required to issue a Form 1099-NEC (Nonemployee Compensation) or a Form 1099-MISC (Miscellaneous Information). These forms inform the IRS that the ultimate recipient received income, even though the intermediary did not recognize it as their own.

For example, a company paying a freelance contractor through a third-party platform might still be responsible for issuing a 1099-NEC to the contractor if the platform doesn’t handle the reporting.

The ultimate recipient is responsible for accurately reporting these funds as income on their own tax return, regardless of whether they receive a Form 1099. The information provided on a 1099 form helps the IRS match reported income with the recipient’s tax filings. Failure to report income, even if it was a pass-through from an intermediary, can lead to penalties and interest charges.

Distinguishing pass-through payments from taxable revenue is important to avoid overstating income and incurring tax liabilities. Businesses must maintain clear records that differentiate funds temporarily held for others from their operational revenue. This proper classification ensures that only the intermediary’s actual fees, commissions, or other earned income are subject to taxation for their business. This also prevents the intermediary from being taxed on money that was never truly theirs.