How Pass-Through Entities Are Taxed

The majority of businesses in the United States (about 95%) are structured as pass-through entities. These companies do not pay corporate income tax. Instead, profits and losses “pass through” to owners, who then report the income on individual tax returns. This can be confusing, especially considering how profits flow down to owners. While this structure avoids double taxation, it also means the tax burden is on the individual level, requiring business owners to consider self-employment taxes, payroll, and state tax limitations. To help clients, prospects, and others, Wilson Lewis has provided a summary of the key details below.

Understanding Pass-Through Tax

Pass-through entities include sole proprietorships, partnerships, S corporations, and most limited liability companies (LLCs). 

Sole Proprietorships — A sole proprietorship is the simplest business structure, where the business and the owner are legally the same entity. All business income is reported on the owner’s personal tax return using Schedule C, and net earnings are subject to both income tax and self-employment tax. Unlike S corporation owners, sole proprietors do not take a salary, meaning all profits are considered personal income.

Since there is no employer to withhold Social Security and Medicare taxes, sole proprietors must pay self-employment tax (15.3%), which covers both the employer and employee portions of these taxes. This amount is separate from federal income tax. The IRS allows a deduction for half of the self-employment tax, which helps reduce taxable income before applying federal tax rates. While sole proprietorships are simple to implement and offer flexibility, the tax burden can be significant, as all profits are subject to self-employment tax. Many owners use estimated quarterly tax payments to manage their tax liability throughout the year.

Partnerships — A partnership is like a sole proprietorship, but it involves two or more owners who share the business’s profits and losses. The business itself does not pay federal income tax; instead, earnings pass through to the partners based on their ownership agreement, and each is taxed on their share of the income. Partners report earnings on their personal tax returns using Schedule K-1. This form reports the partnership’s total income, deductions, and distributions, but the business itself does not pay federal income tax at the entity level.

Like sole proprietors, partners must pay self-employment tax on their share of the business income, covering Social Security and Medicare. Since partnerships do not allow owners to take a salary, all earnings are subject to self-employment tax, regardless of whether profits are distributed or retained in the business. Partners often make estimated quarterly tax payments to cover tax liability throughout the year.

S Corporations — An S corporation is a pass-through entity that allows business owners to split their income between salary and distributions. Unlike sole proprietors and partners, S-corp owners are considered employees of the business and must take a reasonable salary, which is subject to payroll taxes (Social Security and Medicare). However, any remaining profits can be taken as distributions, which are not subject to self-employment tax.

S corporations file Form 1120-S, but the business itself does not pay federal income tax like a C-corp. Instead, each shareholder receives a Schedule K-1, which reports their portion of business income, losses, and deductions. Owners report this income on their personal tax returns, like partnerships.

While S-Corp status can provide tax savings, owners will need to comply with IRS rules to prevent tax issues and penalties. The IRS requires that salaries be reasonable based on industry standards, preventing owners from artificially minimizing wages to avoid payroll taxes. Additionally, since S corporations do not pay self-employment tax directly, business owners must still withhold and pay FICA taxes on salaries.

Limited Liability Companies (LLCs) An LLC provides legal liability protection while maintaining pass-through taxation. By default, single-member LLCs are taxed like sole proprietorships, and multi-member LLCs are taxed like partnerships. 

However, LLCs can elect to be taxed as an S corporation, which allows owners to split earnings between salary and distributions. Without this election, all income is subject to self-employment tax, similar to a partnership or sole proprietorship. This flexibility makes LLCs a popular choice for business owners looking to balance some liability protection and tax efficiency.

Key Considerations

Understanding how pass-through entities are taxed is only part of the equation. Business owners also will want to think about what deductions they qualify for, how state tax rules impact them, and whether upcoming tax law changes could affect their bottom line. Here are a few key areas to keep in mind:

• QBI — Many pass-through businesses may qualify for the Qualified Business Income (QBI) deduction, which allows eligible owners to deduct up to 20% of their business income before calculating taxable income. The deduction is subject to income limits and restrictions based on the type of business, with certain service-based businesses facing phaseouts at higher income levels. 
• State and Local Tax Limitations — The federal deduction for state and local taxes (SALT) is currently capped at $10,000 for individual taxpayers, which can affect pass-through business owners in high-tax states. Some states have introduced pass-through entity tax (PTET) elections, which allows businesses to pay state income taxes at the entity level and bypass the SALT cap. However, PTET rules vary by state, and business owners will need to confirm eligibility. 
• TCJA Sunset — The Tax Cuts and Jobs Act (TCJA) introduced several tax provisions that are set to expire at the end of 2025. For pass-through business owners, this could mean a change to the QBI deduction. If Congress does not extend the provision, businesses that currently qualify for the 20% deduction could see their taxable income increase. The expiration of other TCJA provisions, such as lower individual tax rates and expanded deductions, may also impact pass-through businesses. Business owners will want to start planning now by reviewing how these potential changes could affect their tax liability and whether adjustments to structure or financial planning are needed.
• Entity Changes — For many, the simplest business structure works in the early years. However, as profits increase, tax and financial needs may change. Some LLCs elect S-corp taxation to reduce self-employment taxes. Others decide to switch to a C corporation. These decisions depend on many factors, including income levels, growth plans, and long-term tax strategy. Reviewing entity classification with a professional can help the business choose the most tax-efficient structure.

Contact Us

The process through which pass through entities are tax can be complicated. The expected changes due to sunsetting TCJA provisions and more make tax planning more important than ever. If you have questions about the information outlined above or need assistance with another tax or accounting issue, Wilson Lewis can help. For additional information call 770-476-1004 or click here to contact us. We look forward to speaking with you soon.