What Is a Passthrough Entity and How Is It Taxed?

A pass-through entity represents a business structure where income, losses, deductions, and credits are not taxed at the business level. Instead, these financial elements “pass through” directly to the owners’ personal income, where they are reported and taxed. This tax treatment avoids a separate layer of taxation at the entity level, simplifying the tax process for many small businesses and their owners. The structure allows for the direct allocation of business financial performance to individual tax returns.

Understanding Pass-Through Taxation

The business itself does not pay federal income tax. Profits and losses generated by the entity are reported directly on the owners’ individual income tax returns, specifically on Form 1040. This contrasts with other business structures where the entity might first pay its own income tax. Owners then become responsible for paying taxes on their share of the business’s income at their personal income tax rates, which range from 10% to 37% for 2024, depending on their total taxable income and filing status.

For owners actively involved in the business, their share of the income is generally subject to self-employment taxes. These taxes fund Social Security and Medicare, similar to the FICA taxes withheld from an employee’s paycheck. The self-employment tax rate is 15.3% for 2024, comprising 12.4% for Social Security and 2.9% for Medicare. The Social Security portion applies to net earnings up to a certain annual limit, which is $168,600 for 2024, while the Medicare portion applies to all net earnings. A deduction for one-half of self-employment taxes paid is allowed when calculating adjusted gross income.

Income generated by a pass-through entity retains its character as it flows to the owners. For example, ordinary business income remains ordinary income, and capital gains remain capital gains when reported on the owner’s personal return. This ensures specific tax rules associated with different types of income or loss are applied correctly at the individual level, which can affect their total tax liability.

Common Pass-Through Entity Types

Several common business structures are taxed as pass-through entities. Sole proprietorships represent the simplest form, where the business and owner are considered a single entity for tax purposes. The business’s income and expenses are reported directly on the owner’s personal tax return using Schedule C (Form 1040).

Partnerships involve two or more individuals or entities who agree to share in the profits or losses of a business. These can be general partnerships, where all partners have unlimited liability, or limited partnerships, which include both general and limited partners with varying liability levels. For tax purposes, partnerships file an informational return, Form 1065, and then issue a Schedule K-1 to each partner, detailing their share of income, deductions, and credits.

S corporations are corporations that elect a special tax status with the Internal Revenue Service (IRS) to avoid corporate-level taxation. To qualify, an S corporation must meet specific requirements, such as being a domestic corporation, having no more than 100 shareholders, and having only one class of stock. Similar to partnerships, S corporations file Form 1120-S and then provide a Schedule K-1 to each shareholder, reporting their proportionate share of the company’s income, losses, and deductions.

Limited Liability Companies (LLCs) offer owners liability protection, separating their personal assets from business debts and obligations. For tax purposes, an LLC can elect how it wishes to be taxed. A single-member LLC is typically taxed as a sole proprietorship, reporting on Schedule C. A multi-member LLC is generally taxed as a partnership, filing Form 1065. An LLC can also elect to be taxed as an S corporation or even a C corporation.

Tax Reporting for Pass-Through Entities

Tax reporting for pass-through entities involves specific forms that facilitate the flow of income and deductions to the owners’ individual tax returns. For sole proprietorships, the primary tax form is Schedule C (Form 1040). This schedule is filed directly with the owner’s personal Form 1040 and is used to report all business income and expenses, ultimately calculating the net profit or loss from the business. The net profit from Schedule C is then carried over to the individual’s Form 1040, where it is subject to income tax and self-employment tax.

Partnerships are required to file Form 1065 with the IRS. This form reports the overall financial performance of the partnership, including its income, gains, losses, and deductions. However, Form 1065 itself does not calculate a tax liability for the partnership entity. Instead, the partnership issues a Schedule K-1 to each partner, detailing their specific share of these financial items. Partners then use the information from their Schedule K-1 to report their share of the partnership’s income or loss on their personal Form 1040.

S corporations file Form 1120-S annually with the IRS. This form provides a comprehensive report of the S corporation’s income, deductions, credits, and other financial activities. Similar to partnerships, S corporations then distribute a Schedule K-1 to each shareholder. This Schedule K-1 informs each shareholder of their pro rata share of the S corporation’s income, losses, and other tax items, which they subsequently report on their individual Form 1040.

For Limited Liability Companies (LLCs), the tax reporting forms depend entirely on their tax election. If taxed as a sole proprietorship, they use Schedule C. If taxed as a partnership, they file Form 1065 and issue Schedule K-1s. If an LLC elects S corporation status, it follows the reporting requirements for S corporations, including Form 1120-S and Schedule K-1s.

Distinguishing Pass-Throughs from C Corporations

The distinction between pass-through entities and C corporations lies in their tax treatment, particularly concerning the concept of “double taxation.” A C corporation is recognized as a separate legal and tax entity from its owners. This means that the corporation’s profits are first taxed at the corporate level. The federal corporate income tax rate is a flat 21% as of 2024.

After the C corporation pays taxes on its profits, any remaining earnings distributed to shareholders as dividends are taxed again at the individual shareholder level. This second layer of taxation on distributed profits is known as double taxation. In contrast, pass-through entities avoid this double taxation because profits are only taxed once, at the owner’s personal income tax rate, as they “pass through” to the owners’ individual tax returns.

This single level of taxation for pass-through entities means that business income is directly added to the owners’ other personal income, such as wages or investment income, and taxed accordingly. Owners of pass-through entities pay income tax and, if actively involved, self-employment taxes on their share of the business’s profits. The choice between a pass-through entity and a C corporation often hinges on various factors, including the business’s profit levels, plans for reinvestment versus distribution, and the owners’ individual tax situations.