Pass-through entity: Overview and FAQs

What is a pass-through entity?

A pass-through entity, also known as a flow-through entity, is a business entity in which the profits pass through to the owner or owners of that business and are taxed at the individual tax rate. In other words, this business type is generally not subject to federal income tax. Instead, the entity’s income — and credits, deductions, and losses — are reported on the owner’s individual income tax return and taxed at the individual income tax rate.

This business type is not to be confused with shareholder distribution, in which a shareholder receives money or property from the company.

Most U.S. businesses are pass-through entities, which include S corporations, limited liability companies (LLCs), partnerships, and sole proprietorships. In fact, they employ more than half of the nation’s private-sector workforce and generate more than half of the business income in the U.S.

How does a pass-through entity work?

When a pass-through entity generates a profit, that profit flows through the business and onto the owners' tax returns. The owners then report the business income to the IRS on their individual income tax return and pay the tax accordingly.

The business calculates its net income to determine the liability. Each owner then includes their portion of the entity’s net income on their individual tax return.

In terms of taxes, owners of pass-through entities are also charged with paying state and local taxes (SALT) and self-employment taxes. In many instances, Social Security and Medicare taxes are calculated as self-employment taxes. This is especially the case for sole proprietorships.

For those entities with employees, payroll tax liability must be calculated for both the employee and entity portions.

In some situations, pass-through entities may elect to be taxed at the entity level for state income tax purposes. See the discussion of the pass-through entity tax (PTET) below.

What is the benefit of a pass-through entity?

Pass-through entities have some notable tax benefits over other types of business structures. The key advantages include:

• Double taxation. Pass-through entities avoid double taxation, meaning business income is taxed just once. The entity’s income is reported on the owner’s individual income tax return and taxed at the individual income tax rate. In contrast, C corps are subject to double taxation by default. They must pay a 21% federal business income tax prior to any income reaching their shareholders. A second round of taxation occurs as shareholders must report on their personal tax returns any dividend income they receive — or any gain from the sale of corporate stock.
• Net operating loss. If the pass-through entity reports a net operating loss (NOL), the personal tax liability for the owner gets reduced. The owner can claim an NOL deduction on their personal taxes. However, if a C corp reports an NOL, its shareholders are still required to pay income tax on any earnings they receive.

What are the different types of pass-through entities?

There are four types of pass-through entities — S corporations, limited liability companies (LLCs), partnerships, and sole proprietorships.

• S corporations (S corps). The IRS explains that S corps are pass-through entities because they “pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes,” enabling the entity to avoid double taxation on the corporate income.
• Limited liability companies (LLCs). Unless they elect to be treated as corporations for federal tax purposes, LLCs are considered pass-through entities because they are not subject to corporate income taxes. Instead, the owner reports the proceeds as federal income for the business and is then taxed at the individual income tax rate. 
• Partnerships. Partnerships are pass-through entities because they are not required to pay corporate income tax but rather flow through the profits or losses to the partners. To report income gains, deductions, credits, losses, credits, etc., from the organization, partnerships must file an entity tax return, Form 1065.
• Sole proprietorships. · Sole proprietorships are entities owned and operated by a single individual not subject to corporate income taxes. Instead, the owner reports the proceeds as income and is then taxed at the individual income tax rate. 

In contrast to pass-through entities being taxed on the individual level, C corps and LLCs that elect to be taxed as a corporation are not treated as pass-through entities.

What is the difference between a pass-through entity and a C corp?

There are several notable differences between a pass-through entity and a C corp. The key differences are:

• Unlike pass-through entities, C corps — by default — are subject to paying corporate income taxes at the entity level, with shareholders being taxed on corporate profits when distributed as dividends — or when they sell their corporate stock. This is known as double taxation.
• While owners of pass-through entities must pay taxes on all earnings, C corps are not required to pay taxes on retained earnings or profits that are held for reinvestment back into the operation.
• C corps can typically write off fringe benefits, like paid time off and health insurance. There are different rules for fringe benefits paid to partners in a partnership or greater than 2% shareholders of an S corporation.
• Owners of pass-through entities can deduct charitable contributions if they itemize their deductions. C corps, however, have greater flexibility and can usually make tax-deductible charitable contributions up to 10% of their taxable income.

What is a pass-through entity tax?

A pass-through entity tax (PTET) is a workaround to the state and local tax (SALT) deduction limit, enabling eligible pass-through entities to be taxed at the entity level for state income tax purposes. In short, a key benefit of PTET is that owners of eligible pass-through entities can avoid the $40,000 SALT deduction cap for state and local taxes on federal individual tax returns. The SALT cap can prove especially costly for owners of S corporations and partnerships, so a PTET election can be an attractive move.

The Tax Cuts and Jobs Act of 2017 (TCJA) limited an individual’s SALT deduction to $10,000. The One Big Beautiful Bill Act (OBBBA) made the cap permanent, but increased it to $40,000 for 2025, subject to a phasedown. C corporations, which pay taxes at the entity level, do not have a limit on their SALT deductions.

Since the passage of the TCJA, numerous states have taken a closer look at — and implemented — the workaround to the SALT cap. Each state that has enacted legislation to create a pass-through entity tax has different regulations, which can make it incredibly complicated for businesses that operate across state lines.

The first state to enact a pass-through entity tax as a workaround to the SALT cap was Connecticut, which enacted the tax in April 2018. Pass-through entity taxes in Connecticut are mandatory. However, the taxes are elective in most states.

Today, more than 30 states have enacted legislation that creates a pass-through entity tax. Hawaii, Iowa, and Indiana are among the most recent states; they enacted pass-through entity tax effective 2023. Since then, some states have modified or extended their PTET regimes.

Reducing an owner’s income tax liability hinges on such factors as their state’s tax rates, deduction limits for individuals versus for a pass-through entity, and credits. It should be noted that electing pass-through entity taxes is not always beneficial for all individual owners, as several factors need to be considered.

Although the OBBBA significantly increased the SALT cap to $40,000 for 2025, it may still be beneficial for pass-through entities to make the PTET election. For example, if a partnership is engaged in a trade or business, deducting the entity-paid PTET against business income lowers the partners’ shares of self-employment (SE) income. On the other hand, state income taxes paid by the partners do not reduce their SE income, even if those taxes are attributable to SE income passed through by the partnership.

What is the Section 199A pass-through deduction?

The Section 199A deduction is a qualified business income deduction (QBID). This deduction may be available to individuals who earn income from a pass-through business. It allows them to deduct up to 20% of their Qualified Business Income (QBI). Furthermore, taxpayers can deduct up to 20% of qualified Real Estate Investment Trust (REIT) dividends and qualified publicly traded partnership (PTP) income.

The 2017 Tax Cuts and Jobs Act created the deduction, and the OBBBA made it permanent.

Which states conform to IRC 199A pass-through deduction?

The state tax treatment of the Section 199A QBI deduction depends on the state’s conformity to the Internal Revenue Code (IRC) and each state’s decoupling provisions. States follow different approaches in adopting conformity to the IRC, resulting in inconsistent state tax treatment of federal QBI rules.

For more information on a particular state’s conformity to the QBI deduction, see the State Charts tool on Checkpoint, available in CoCounsel Tax.