Should Your Business Be a Pass-Through Entity? A Guide for Entrepreneurs

A pass-through entity is a business that does not pay income tax of its own. Instead, the business’s income, losses, credits, and deductions “pass-through” to the business owner's personal tax return; are calculated according to an owner’s individual income tax rate.

Ease of tax filing is among the primary reasons why entrepreneurs choose to operate their businesses on a pass-through basis. Sometimes business owners start their companies as pass-through entities and then incorporate at some point in the future as their organizations grow and evolve.

What kinds of business entities are pass-through entities?

Sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies, and S Corporations are all pass-through entities. Corporations and limited liability companies that elect to be taxed as a C Corporation are not pass-through entities.

How do you pay yourself if your business is a pass-through entity?

Business owners of sole proprietorships, general partnerships, and LLCs do not receive compensation in the form of wages and salaries because they are not considered employees of their company. They instead get paid through “owner’s draws.” An owner’s draw is when a business owner takes money out of their share of the company’s profits. Typically, they do that by writing themselves a business check or transferring funds from the business to their personal bank account (if their bank will allow it).

Note that LLCs and Corporations that opt for S Corporation election, although also considered pass-through entities, do things a little differently. S Corps must put owners who work in the business on payroll and pay them a reasonable wage or salary for the work they perform.

How does pass-through entity tax treatment work?

Income tax obligations for a pass-through entity flow through to the business owner's individual tax return. Business profits are taxed at the individual tax rate applicable to the owner rather than at the corporate tax rate. This can be advantageous if the owner’s individual tax rate is lower than the corporate tax rate. Because many factors can affect which business structure will be ideal from a tax perspective, it’s helpful for business owners to get insight and guidance from an accountant or other tax professional.

General information about federal income tax and pass-through entities

Sole proprietorships

The income tax filing for the business goes on Schedule C of the owner’s personal tax return, with the net income or loss passed through to Schedule 1 of IRS Form 1040.

Single-member LLCs

Income tax for single-owner LLCs is handled the same way as for sole proprietorships.

General partnerships

Business income or loss is divided among the owners (“partners”) according to their distributive share percentage (as described in the company’s partnership agreement). The partnership reports its income and losses on a partnership return (IRS Form 1065). Each partner receives a Schedule K-1 from the partnership, showing their share of the business profits, and each partner must include information from Schedule K-1 on Schedule E of their personal tax return.

Multi-member LLCs

The IRS treats multi-member LLCs the same as partnerships; owners are taxed as partners.

S Corporation

Business income taxes pass through to the business owners, but tax filing requirements depend on the underlying business entity (LLC or C Corporation). An S Corp is not a type of business entity but rather a special IRS tax election that eligible LLCs and C Corporations may request. More information can be found on the IRS website.

How has the Tax Cuts and Jobs Act affected pass-through businesses?

The Tax Cuts and Jobs Act (TCJA), which was passed into law at the end of 2017, created tax reforms that allow many pass-through entities to claim a 20% deduction of their share of qualified business income (QBI) before paying federal income taxes. Here are some of the main highlights about the TCJA:

The deduction must be equal to 20% of the QBI earned from the business.
Not all business income is considered to be QBI.
The deduction is restricted to the lesser of 20% of the business’s QBI or 50% of the total W-2 wages paid by the business.
An income threshold exists for businesses in which “the principal asset is the reputation or skill of one or more of its employees or owners.” If their income reaches a particular amount, they may not be eligible for the deduction. Generally, the industries affected are health, law, accounting, performing arts, consulting, athletics, financial services, and some others.
Other limitations apply to pass-through entities (besides service providers) if taxable income exceeds certain thresholds.

It’s helpful for business owners to get professional tax assistance when calculating the pass-through deduction and preparing tax forms because there may be other restrictions and circumstances to consider.

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What about self-employment taxes?

Sole proprietorships, partnerships, and LLCs

It’s not uncommon to hear pass-through business owners express dismay about their self-employment tax burden. As self-employed individuals, they are subject to self-employment taxes under SECA (the Self-Employment Contributions Act of 1954). Self-employment taxes include Social Security and Medicare taxes; they’re essentially the same taxes as FICA on paychecks.

However, self-employed individuals must pay the entire 12.4% Social Security tax and 2.9% Medicare tax, whereas employees only pay half of those taxes because their employers pay the other half. Usually, pass-through entity owners must file and pay their self-employment taxes in quarterly installments, along with their estimated income taxes.

S Corporations

By electing S Corp tax treatment, business owners can lessen their self-employment tax burden. Their “employee income” from their wages and salaries from the business is subject to 50% of the Social Security and Medicare taxes; those taxes are withheld from their paychecks. Meanwhile, the S Corp (the employer) pays the other half of those taxes—and the remaining business profits paid as distributions to the business owners are not subject to self-employment taxes (note that they’re still subject to income taxes, though).

It’s critical that entrepreneurs pay themselves a reasonable salary for the work they perform for the S Corp. The IRS may come calling if they suspect business owners are gaming the system. It’s a no-no for an S Corp to pay its owners unreasonably low wages to leave more money for self-employment-tax-free distribution payments.

Pros and cons of being a pass-through entity

Potential pros

1. Not subject to double taxation—C Corporations must pay tax twice (at the corporate level and then on the business owner’s individual tax returns) on income that is then paid as dividends to shareholders.

2. Easy to start—No entity registration paperwork is required to form sole proprietorships or general partnerships. These structures are assumed as soon as someone begins conducting business. Forming an LLC is relatively simple, too. It requires filing formation paperwork (Articles of Organization) with the state, but doesn’t come with the requirements of corporate bylaws or establishing a board of directors. For an LLC to be treated as an S Corp for tax purposes, it must file IRS Form 2553.

3. Fewer business compliance responsibilities—Pass-through businesses generally undergo less government oversight and have fewer compliance filings than corporations.

Potential cons

1. Might not be an ideal tax situation—With business profits flowing through to the business owners, it could put some entrepreneurs in a higher individual tax bracket. That might result in paying more tax overall than they would if the business would have been incorporated. Also, the self-employment tax burden might prove prohibitive for owners of sole proprietorships, partnerships, and LLCs.

2. Might put business owners’ personal assets at risk—Sole proprietors and general partners are not protected from their business’s liabilities. The owners and their business are considered the same legal entity and therefore there’s no separation of their assets or legal responsibilities. Alternatively, the LLC and S Corp provide their owners with limited liability protection. Under most circumstances, owners’ personal assets are protected from debts and legal actions against their companies. C Corporations have the greatest level of personal liability protection, offering peace of mind to business owners and certain stakeholders.

3. Difficulty attracting investors—Many investors are only willing to invest in businesses that have incorporated.

Incorporating vs pass-through: how to decide

Entrepreneurs have a lot to consider when deciding if it will be advantageous to incorporate or set up their business as a pass-through entity. With significant legal and financial implications, it’s wise for business owners to consult an attorney and accountant or tax advisor to assess their unique situation and understand the impact of their decision. Also, it can benefit existing pass-through business owners to review their entity selection every few years to determine if it’s still the best choice for their growing company.