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What Is a Pass-Through Entity? How Pass-Through Taxation Works
A pass-through entity is a business that pays no federal income tax itself. Its profit passes through to the owners, who report it on their own returns and pay tax whether or not the cash is distributed. Sole proprietorships, single-member LLCs, partnerships, multi-member LLCs and S corporations are pass-throughs. A C corporation is not: it pays the 21% corporate tax, and shareholders pay again on dividends.
“Pass-through entity” is not a term the Internal Revenue Code defines; it describes what the Code does to partnerships, S corporations and disregarded businesses: it looks through them and taxes the owners. This guide covers which entities pass through, how the income reaches the owner, why owner pay is taxed differently in each, the QBI deduction, the cases where a pass-through still owes tax itself, and the limits on passing losses through. Choosing among the pass-throughs and a C corporation is a separate decision, made in LLC vs S corp vs C corp.
Which entities are pass-throughs
| Entity | Entity return | Where the owner reports it | Employment tax on owner pay |
|---|---|---|---|
| Sole proprietorship or single-member LLC | None separate; Schedule C goes with the owner’s Form 1040 | Schedule C net profit on Form 1040 | Self-employment tax on net earnings (Schedule SE) |
| Partnership or multi-member LLC | Form 1065, an information return, with a Schedule K-1 per partner | Schedule E, Part II, from the K-1 | Self-employment tax on a general partner’s share and guaranteed payments; limited partners only on guaranteed payments for services |
| S corporation (including an LLC that elected S status) | Form 1120-S with a Schedule K-1 per shareholder | Schedule E, Part II, from the K-1; salary on a W-2 | Payroll taxes on the reasonable salary only; the K-1 share is not self-employment income |
| C corporation (for contrast) | Form 1120; the corporation pays 21% itself | Dividends on Form 1099-DIV; salary on a W-2 | Payroll taxes on salary; no employment tax on dividends, which were already taxed at 21% |
An LLC lands in one of the first three rows depending on its member count and elections: disregarded with one member, a partnership with two or more, or an S corporation if it files Form 2553 (Treas. Reg. 301.7701-3(b)(1); Publication 3402). Only an LLC that elects C corporation treatment leaves the pass-through group. The Schedule C instructions say a single-member domestic LLC “is not treated as a separate entity for federal income tax purposes” unless it made that election (Schedule C instructions).
How income reaches the owner: K-1 or Schedule C, taxed whether or not distributed
The statute is blunt. A partnership “as such shall not be subject to the income tax”; its partners “shall be liable for income tax only in their separate or individual capacities” (IRC 701). An S corporation “shall not be subject to the taxes imposed by this chapter” except where subchapter S says otherwise (IRC 1363(a)). Each partner takes into account a distributive share of the partnership's income, gains, losses, deductions and credits (IRC 702(a)), and each S corporation shareholder takes a pro rata share of the corporation's items (IRC 1366(a)). The character of each item survives the trip: capital gain inside the entity is capital gain to the owner, because the item is treated “as if such item were realized directly from the source from which realized by the partnership” (IRC 702(b)), with the same rule for S corporations (IRC 1366(b)).
Timing is the part owners underestimate. Both K-1 instructions say the owner “may be liable for tax on your share of the” entity's income “whether or not distributed” (Partner's K-1 instructions; Shareholder's K-1 instructions). Profit the business keeps for working capital is still taxed to you this year. How the shares are sized also differs. A partnership allocates by the partnership agreement, provided the allocation has substantial economic effect; otherwise by the partner's interest in the partnership (IRC 704(b)). An S corporation has no such flexibility: each item is assigned equally to each day and divided pro rata among the shares outstanding that day (IRC 1377(a)(1)), which is the one-class-of-stock rule in arithmetic form.
Owner pay and self-employment tax differ by entity
A sole proprietor or single-member LLC owner is not an employee of the business and pays self-employment tax on the net earnings (Publication 3402): 12.4% for Social Security and 2.9% for Medicare (IRC 1401) on 92.35% of net earnings (IRC 1402(a)(12)), with the Social Security part stopping at the $184,500 wage base for 2026 (Publication 15). A general partner pays it on the distributive share plus guaranteed payments; a limited partner's distributive share is excluded, other than guaranteed payments for services (IRC 1402(a)(13); Schedule SE instructions).
An S corporation flips the mechanics. A shareholder who works in the business is a corporate officer and therefore an employee, paid a reasonable salary through payroll before any distributions (IRS compensation page); the remaining profit comes through on the K-1, and that share “isn't self-employment income and it isn't subject to self-employment tax” (Shareholder's K-1 instructions). The salary question and the monthly routine are in what is a reasonable salary for an S corp owner and how to pay yourself from an S corp.
The QBI deduction belongs to pass-through owners
Section 199A allows “a taxpayer other than a corporation” a deduction of up to 20% of qualified business income from a pass-through, limited to 20% of taxable income over net capital gain (IRC 199A(a)). Reasonable compensation from an S corporation and guaranteed payments from a partnership are not qualified business income (IRC 199A(c)(4)). Above a taxable income threshold, $201,750 for 2026, or $403,500 on a joint return (Rev. Proc. 2025-32), wage and property limits phase in and specified service businesses phase out. The computation, Form 8995 and the 2026 ranges are covered in what is the QBI deduction.
When a pass-through still owes tax at the entity level
Two federal taxes reach an S corporation directly, and both trace back to C corporation history. The built-in gains tax applies when a corporation that converted from C status sells appreciated assets during the five-year recognition period, at the highest corporate rate (IRC 1374). The tax on excess net passive income applies when an S corporation still holds C corporation earnings and profits and more than 25% of its gross receipts are passive investment income, again at the corporate rate (IRC 1375(a)). A corporation that has always been an S corporation and has no C corporation earnings owes neither, and the Form 1120-S instructions note that shareholders are taxed on their shares of income reduced by any taxes the corporation paid (Form 1120-S instructions).
States add a third case by choice. Many states let a partnership or S corporation elect to pay state income tax at the entity level, and Notice 2020-75 says such “Specified Income Tax Payments” are deductible by the entity in computing its non-separately stated income and are not taken into account in applying the SALT deduction limitation to the individual owners (Notice 2020-75, section 3.02). Which states offer the election, the deadlines and the credits owners receive are covered in what is PTET.
Losses pass through too, up to four limits
A loss year flows to the owner the same way, but four limits apply in a fixed order, which both K-1 instructions list as “the basis limitations, the at-risk limitations, the passive activity limitations, and the excess business loss limitations.” A partner's loss is allowed only to the extent of the adjusted basis of the partnership interest (IRC 704(d)); a shareholder's only to the extent of stock basis plus the basis of loans the shareholder made to the corporation (IRC 1366(d)(1)), with the excess carried forward. Losses are then limited to the amount at risk (IRC 465), to passive income if the owner does not materially participate (IRC 469), and finally to the excess business loss threshold, $256,000 for 2026 or $512,000 on a joint return, with the rest treated as a net operating loss carryover (IRC 461(l); Rev. Proc. 2025-32). Basis also decides whether cash coming out is taxable, which is the subject of how S corp distributions are taxed.
Anthony leads sales at Business Executive Group, a national HR services firm that runs payroll for partnerships, LLCs and S corporations. Tax planning work is done by licensed tax professionals at BEG's tax partner.
Sources: 26 U.S.C. 701, partners, not partnership, subject to tax; 26 U.S.C. 702, income and credits of partner; 26 U.S.C. 704, partner’s distributive share; 26 U.S.C. 1363, effect of election on corporation; 26 U.S.C. 1366, pass-thru of items to shareholders; 26 U.S.C. 1377, pro rata share; 26 U.S.C. 1374, tax on built-in gains; 26 U.S.C. 1375, tax on passive investment income; 26 U.S.C. 11, tax imposed on corporations; 26 U.S.C. 1401 and 1402, self-employment tax; 26 U.S.C. 199A, qualified business income; 26 U.S.C. 465, deductions limited to amount at risk; 26 U.S.C. 469, passive activity losses; 26 U.S.C. 461(l), limitation on excess business losses; 26 CFR 301.7701-3, classification of certain business entities; IRS, Partner’s Instructions for Schedule K-1 (Form 1065) (2025); IRS, Shareholder’s Instructions for Schedule K-1 (Form 1120-S) (2025); IRS, Instructions for Form 1120-S (2025); IRS, Instructions for Schedule C (Form 1040) (2025); IRS, Instructions for Schedule SE (Form 1040) (2025); IRS, Schedule E (Form 1040) (2025); IRS, Publication 3402, Taxation of Limited Liability Companies; IRS, Publication 15 (2026), Employer’s Tax Guide; IRS, S corporation compensation and medical insurance issues (reviewed March 3, 2026); IRS, Rev. Proc. 2025-32, 2026 inflation adjustments; IRS, Notice 2020-75, state and local income taxes paid by partnerships and S corporations. Figures and rules checked against these sources on September 26, 2026. This is general information, not tax advice for your situation. Tax services are provided by licensed tax professionals under a separate engagement agreement. BEG does not provide tax advice.
Pass-through entity questions
Is an LLC a pass-through entity?
By default, yes. A single-member LLC is disregarded and reports on its owner’s Schedule C; an LLC with two or more members is a partnership that files Form 1065 and issues K-1s. It stops being a pass-through only if it files Form 8832 to be taxed as a C corporation. An LLC that elects S status is still a pass-through.
Is an S corp a pass-through entity?
Yes. IRC 1363(a) says an S corporation is generally not subject to the income tax, and IRC 1366 passes its items of income, loss, deduction and credit to the shareholders pro rata. The exceptions are the built-in gains tax and the tax on excess passive income, which apply only to corporations that were once C corporations or hold C corporation earnings.
Do pass-through owners pay tax on money they never received?
Yes. Both sets of K-1 instructions say the owner may be liable for tax on their share of the entity’s income whether or not it is distributed. The usual answer is a distribution large enough to cover the tax, which is why partnership agreements and S corporation owners plan tax distributions around the estimated tax due dates.
What is the difference between pass-through taxation and double taxation?
A pass-through is taxed once, at the owners’ rates. A C corporation’s profit is taxed twice: 21% at the corporate level under IRC 11(b), then again when it is paid to shareholders as a dividend. The trade-off is that a C corporation can hold profit at 21% without a current tax to its owners.
Do pass-through entities pay self-employment tax?
The entity does not; the owners might. A sole proprietor or general partner pays 15.3% self-employment tax on net earnings, with the 12.4% Social Security part capped at $184,500 of earnings in 2026. An S corporation shareholder pays payroll taxes on salary instead, and the K-1 share is not self-employment income.
Can a pass-through entity have employees?
Yes. A partnership or S corporation runs payroll like any employer, and a single-member LLC files employment tax returns under its own name and EIN even though it is disregarded for income tax. What differs is whether the owner is on that payroll: S corporation officers who work in the business are; sole proprietors and partners are not.
What is a pass-through entity tax (PTET)?
A state income tax that a partnership or S corporation elects to pay at the entity level. Notice 2020-75 says such payments are deductible by the entity in computing its non-separately stated income and are not taken into account in applying the SALT deduction limitation to the individual owners. Which states offer it, and on what terms, is covered in the PTET post.
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