When you own a business, how your income is taxed can significantly affect your bottom line. One of the most common and beneficial tax structures in the U.S. is the pass-through entity, also known as a flow-through entity.
But what exactly does this mean, and why do so many businesses choose it?
What Is a Pass-Through Entity?
A pass-through entity is a business structure in which profits (and losses) “pass through” the business directly to the owners’ personal income tax returns. In other words, the business itself does not pay federal income tax. Instead, the tax responsibility lies with the individual owner(s), who report the entity’s income on their personal tax filings and are taxed at their individual income tax rate.
This structure differs from a C corporation, where the business pays corporate taxes, and shareholders are taxed again on distributions, a system known as double taxation.
Most U.S. businesses fall under the pass-through category, including:
- S corporations
- Limited liability companies (LLCs)
- Partnerships
- Sole proprietorships
Together, these entities employ more than half of the U.S. private-sector workforce and account for more than half of the nation’s business income.
How Does a Pass-Through Entity Work?
When a pass-through entity earns a profit, that income is allocated to the owner(s) based on their ownership percentage. Each owner then reports their portion of the business’s net income on their personal tax return.
In addition to federal income taxes, pass-through entities must also account for:
- State and local taxes (SALT)
- Self-employment taxes (especially for sole proprietors)
- Payroll taxes, where applicable
If the business has employees or multiple owners, those tax calculations can become more complex, including the employer and employee portions of payroll taxes.
Why Choose a Pass-Through Entity?
There are several tax advantages to operating as a pass-through entity:
Avoiding Double Taxation
Unlike C corporations, pass-through entities do not pay taxes at both the corporate and individual levels. Profits are taxed only once on the owner’s individual return.
Net Operating Loss (NOL) Benefits
If a pass-through business reports a loss, owners may be able to deduct that loss on their personal tax returns, reducing their overall tax burden. In contrast, C corp shareholders must still pay taxes on distributions, even if the corporation reports a loss.
Types of Pass-Through Entities
- S Corporations (S Corps): S corps pass income, deductions, and credits to shareholders, helping avoid corporate-level tax. They must meet specific IRS eligibility requirements.
- Limited Liability Companies (LLCs): LLCs are flexible and can be taxed as pass-through entities by default or elect to be taxed as corporations. Single-member LLCs are treated like sole proprietorships, while multi-member LLCs resemble partnerships.
- Partnerships: Income or losses flow through to the individual partners. Partnerships must file Form 1065 to report income and distribute K-1 forms to partners.
- Sole Proprietorships: The simplest form of business ownership: one person owns and operates the business, and all income is reported directly on the individual’s tax return.
How Do Pass-Through Entities Compare to C Corporations?
| Feature | Pass-Through Entity | C Corporation |
| Tax Level | Individual only | Corporate & individual (double) |
| SALT Deduction Cap | Can be limited | Not applicable |
| Retained Earnings Taxed? | Yes | No (until distributed) |
| Fringe Benefits | Limited deductions | Often fully deductible |
| Charitable Contributions | Itemized deduction
(if applicable) |
Up to 10% of taxable income |
What Is a Pass-Through Entity Tax (PTET)?
The Pass-Through Entity Tax (PTET) is a state-level workaround designed to bypass the federal $10,000 cap on state and local tax (SALT) deductions for individuals: a cap introduced under the 2017 Tax Cuts and Jobs Act (TCJA).
With PTET, the pass-through entity pays state income taxes at the entity level rather than passing it to the owner’s personal return, allowing for a full deduction on the business’s federal tax filing.
Since 2018, over 30 states, including Connecticut (mandatory) and others (elective), have adopted some form of PTET. However, each state sets its own rules, making compliance more complicated for businesses operating across state lines.
What Is the Section 199A Deduction?
The Section 199A deduction (also known as the Qualified Business Income Deduction or QBID) allows eligible pass-through business owners to deduct up to 20% of their qualified business income, as well as 20% of qualified REIT dividends and PTP income.
This deduction is only available to:
- Sole proprietorships
- Partnerships
- S corporations
- Certain trusts and estates
C corporations do not qualify.
The QBID is part of the 2017 TCJA and is scheduled to expire at the end of 2025, unless extended by future legislation.
Closing Thoughts
For many business owners, a pass-through entity structure offers a more tax-efficient way to operate, especially when taking into account the benefits of avoiding double taxation, claiming potential deductions, and leveraging PTET and Section 199A provisions.
That said, choosing the right business structure depends on your specific goals, tax situation, and plans for growth. The rules can be complex, especially when multiple owners or states are involved, so it’s essential to work with a tax professional who understands your business.
Have questions about pass-through entities or need guidance on structuring your business tax-efficiently?
Contact ACap Advisors & Accountants, our team is here to help you navigate the options and make the smartest decisions for your financial future.
