Glossary
Pass-through entity
A pass-through entity is a business structure legally akin to the individual(s) who owns it. It gets taxed at individual income tax rates and reports its income on the individual income tax returns of the business owner(s). A pass-through entity, which is different from a C corporation, is the most common business structure within the United States.
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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(s) of that business and are taxed at the individual tax rate. In other words, this business type is not subject to federal income tax. Instead, the entity’s income — and credits, deductions, or losses — is 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.
The majority of 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, 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 multiple owners and employees, the owners must calculate their payroll tax liability for both the employee and owner sides.
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 owners are taxed just once. The corporate 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.
- 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). LLCs are considered pass-through entities because they are not subject to corporate income taxes. Instead, the owner(s) 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 and are taxed again when earnings are distributed to the shareholders. This is known as double taxation.
- While 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.
- Unlike pass-through entities, C corps can typically write off fringe benefits, like paid time off and health insurance.
- 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 eligible pass-through entities can avoid the $10,000 SALT deduction cap on deducting state and local taxes on federal individual tax returns. The SALT cap can prove especially costly for 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. This provision is set to expire after 2025 unless it is extended. 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 $10,000 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 all other states.
Today, more than 30 states have enacted legislation that creates a pass-through entity tax. Hawaii, Montana, and Missouri are among the most recent states; they enacted pass-through entity tax effective 2023.
Reducing a shareholder’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 for pass-through entity taxes is not always beneficial for all individual shareholders, as several factors need to be considered.
What is the Section 199A pass-through deduction?
The Section 199A deduction is a qualified business income deduction (QBID) that may be available to individuals with pass-through business income to deduct up to 20% of their QBI, plus up to 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. This deduction applies to sole proprietorships, partnerships, S corporations, and some trusts and estates. Income earned by a C corp is not eligible.
The 2017 Tax Cuts and Jobs Act created the deduction. Unless extended or made permanent, this deduction will expire on December 31, 2025.
Which states conform to IRC 199A pass-through deduction?
| State | Conformity to IRC § 199A pass-through deduction |
AK |
N/A |
AL |
No. Alabama's personal income tax calculation does not begin with the federal tax base. |
AR |
No. Arkansas does not conform to the IRC § 199A because the state's personal income tax calculation does not begin with the federal tax base. |
AZ |
No. Arizona's personal income tax calculation starts with federal adjusted gross income. |
CA |
No. California's personal income tax calculation starts with federal adjusted gross income. California's IRC conformity date precedes the enactment of IRC § 199A. |
CO |
No. For tax years beginning on or after January 1, 2021, but before January 1, 2023, Colorado decouples from the IRC § 199A qualified business income — pass-through — deduction. For tax years beginning after 2017 and before 2021, Colorado's personal income tax calculation starts with federal taxable income. Colorado conforms to the IRC on a rolling basis and did not decouple from IRC § 199A for these tax periods. |
CT |
No. Connecticut's personal income tax computation begins with federal adjusted gross income. |
DC |
No. The District of Columbia's personal income tax calculation starts with federal adjusted gross income as determined for the applicable tax year. However, the District of Columbia has passed legislation making the IRC § 199A deduction inoperative for personal income tax purposes, effective for tax years beginning on or after January 1, 2018. |
DE |
No. Delaware's personal income tax computation begins with federal adjusted gross income. In addition, while Delaware permits individual taxpayers to take itemized deductions with modifications, the IRC §199A deduction is not an itemized deduction. |
FL |
N/A |
GA |
No. Georgia's personal income tax calculation starts with federal adjusted gross income. In addition, while Georgia permits individual taxpayers to take itemized deductions with modifications, the IRC § 199A deduction is not an itemized deduction. |
HI |
No. Applicable to taxable years beginning after December 31, 2017, IRC Section 199A is not operative for Hawaii tax purposes. |
IA |
No. Iowa does not conform to the IRC § 199A qualified business income — pass-through — deduction because Iowa's personal income tax calculation starts with federal adjusted gross income. Iowa permits individual taxpayers to take itemized deductions to the same extent allowable on a federal return, which would not include amounts under IRC § 199A. Further, for tax years prior to the 2019 calendar year, Iowa does not conform to changes resulting from the Tax Cuts and Jobs Act, including the IRC § 199A deduction for income from pass-through entities. The IRC § 199A deduction is allowed, beginning in 2019, when Iowa's IRC conformity date will be March 24, 2018. For tax years 2019 and 2020, the deduction allowed is 25% of the federal deduction. For tax year 2021, 50% of the federal deduction will be allowed. For tax year 2022, 75% of the federal deduction will be allowed. For tax year 2023, 100% of the deduction will be allowed, contingent on meeting revenue targets. This is because the revenue trigger would cause federal taxable income, rather than federal adjusted gross income, to be the starting point for tax calculations. |
ID |
Yes. Idaho's personal income tax calculation starts with federal taxable income as determined under the IRC, as amended, as of a specific date. |
IL |
No. The personal income tax calculation in Illinois starts with federal adjusted gross income. Individual taxpayers are not allowed to take standard or itemized deductions and are not otherwise permitted to deduct an amount equal to the IRC § 199A deduction. |
IN |
No. Indiana's personal income tax calculation starts with federal adjusted gross income. Indiana conforms to the IRC as amended and in effect on January 1, 2023; however, the deduction of qualified business income under IRC § 199A reduces federal taxable income rather than federal adjusted gross income. For estates and trusts, the federal deduction allowable under IRC § 199A for qualified business income is required to be added back in determining taxable income. |
KS |
No. The personal income tax calculation in Kansas starts with federal adjusted gross income. Itemized deductions are based on deductions from federal adjusted gross income as provided under the IRC. The IRC § 199A deduction is not taken from federal adjusted gross income, so it is not permitted for Kansas income tax purposes. |
KY |
No. Kentucky personal income tax law has decoupled from IRC §199A. |
LA |
No. Louisiana's personal income tax calculation starts with federal adjusted gross income. In addition, while Louisiana allows taxpayers to take certain deductions from adjusted gross income, the IRC § 199A deduction is not among them. |
MA |
Yes. The personal income tax calculation in Massachusetts starts with federal adjusted gross income as determined under the IRC as in effect on January 1, 2022, which includes the enactment of IRC § 199A.
|
MD |
No. Maryland's personal income tax calculation starts with federal adjusted gross income. In addition, while Maryland allows individual taxpayers to take certain deductions from adjusted gross income, permitted amounts are based on federal itemized deductions, so do not include the IRC § 199A deduction. |
ME |
No. Maine's personal income tax calculation starts with federal adjusted gross income as determined under the IRC as in effect on a specific date. Although Maine allows taxpayers to take certain deductions from adjusted gross income, amounts are based on federal itemized deductions, so the IRC § 199A deduction is excluded. |
MI |
No. Michigan's personal income tax calculation starts with federal adjusted gross income. In addition, while Michigan allows individuals to take certain enumerated deductions, such deductions do not include the IRC § 199A deduction. |
MN |
No. Effective retroactively for taxable years beginning after December 31, 2017, for trusts and estates, the amount deducted under IRC § 199A in computing the trust’s or estate's federal taxable income must be added back for Minnesota income tax purposes. |
MO |
No. Missouri's personal income tax calculation starts with federal adjusted gross income. In addition, the Missouri itemized deduction of a resident individual means the allowable federal itemized deductions with certain modifications. Because the IRC § 199A deduction is not a federal itemized deduction, it is not a Missouri itemized deduction. However, Missouri does have a business income deduction that functions similarly to IRC § 199A, and the maximum percentage that may be deducted is 20% — 25% until December 31, 2018 — of business income. |
MS |
No. Mississippi's personal income tax calculation does not begin with the federal tax base. Further, Mississippi allows only certain enumerated deductions and there is no statutory provision for the IRC § 199A deduction. |
MT |
No. The deduction provided under IRC § 199A is not allowed for the computation of Montana personal net income. The deduction was placed under IRC § 63 as a standalone reduction of federal taxable income and was not intended to impact states that use federal adjusted gross income as a starting point for calculating state individual income tax. |
NC |
No. North Carolina's personal income tax calculation starts with federal adjusted gross income. North Carolina individual taxpayers are permitted to deduct either the standard deduction or the itemized deduction amount that the taxpayer claimed under the IRC. Because the IRC § 199A deduction is not an itemized deduction, it is not allowed by North Carolina. |
ND |
Yes. |
NE |
No. Nebraska's personal income tax calculation starts with federal adjusted gross income. Nebraska allows individuals to take either a standard deduction or a deduction based on federal itemized deductions, which does not include the IRC §199A deduction. |
NH |
No. New Hampshire's interest and dividends tax calculation does not begin with the federal tax base. No deductions are allowed in calculating the interest and dividends tax due. |
NJ |
No. New Jersey does not permit a deduction for qualified business income from pass-throughs. |
NM |
No. New Mexico's personal income tax calculation starts with federal adjusted gross income. In addition, while New Mexico permits individual taxpayers to take itemized deductions as defined in IRC § 63, the IRC § 199Adeduction is not an itemized deduction. |
NV |
N/A |
NY |
No. New York's personal income tax calculation starts with federal adjusted gross income. In addition, under NY Tax Law § 615(a) — as amended by NY Budget Bill, L. 2018, S7509 — resident individuals that itemize federal deductions may take a New York itemized deduction equal to "the total amount of ... deductions from federal adjusted gross income ... as provided in the laws of the U.S. … as such deductions existed immediately prior to the enactment of Public Law 115-97." Because New York allows only the deductions permitted under U.S. law prior to the enactment of TCJA, no IRC § 199A deduction is permitted under NY law. |
OH |
No. Ohio's personal income tax calculation starts with federal adjusted gross income. In addition, Ohio allows only specified deductions for personal income tax purposes; the IRC § 199A deduction is not among them. |
OK |
No. Oklahoma's personal income tax calculation starts with federal adjusted gross income. |
OR |
No. While Oregon's personal income tax calculation starts with federal taxable income, Oregon decoupled from the pass-through deduction, and provisions of the IRC that relate to the definition of taxable income apply, as in effect, for the applicable tax year. |
PA |
No. Pennsylvania does not conform to the IRC § 199A because the state's personal income tax calculation does not begin with the federal tax base. |
RI |
No. Rhode Island's personal income tax calculation starts with federal adjusted gross income. Rhode Island permits individuals to take only the Rhode Island standard deduction and does not permit itemized or additional deductions. Therefore, no IRC § 199A deduction is allowed. |
SC |
No. South Carolina conforms with the IRC as of a specified date and specifically decouples from IRC § 199A. South Carolina provides a 3% tax rate on pass-through active trade or business income. |
SD |
N/A |
TN |
No. Qualified business income is not subject to Tennessee's personal income tax, and there is no deduction permitted for 20% of that income. |
TX |
N/A |
UT |
No. Utah's personal income tax calculation starts with federal adjusted gross income. Utah does not allow individual taxpayers to take a standard, itemized, or additional deduction from federal adjusted gross income. Instead, Utah allows a limited itemized deduction or standard deduction credit — each based on the federal standard or itemized deduction — which does not take the IRC § 199A deduction into account. |
VA |
No. Virginia's personal income tax calculation starts with federal adjusted gross income. Virginia allows individual taxpayers to take either a standard or itemized deduction based on the amount taken at the federal level. Because the IRC § 199A deduction is not included in the standard or itemized deduction under the IRC, the deduction is not permitted for Virginia personal income tax purposes. |
VT |
No. Vermont's personal income tax calculation starts with federal adjusted gross income; thus, the 199A deduction does not affect or reduce Vermont tax liability. For taxpayers who do not itemize at the federal level, Vermont allows the amount of the standard deduction taken at the federal level to be deducted from federal adjusted gross income. Taxpayers who itemize at the federal level may deduct the amount of federally itemized deductions for medical and dental expenses and charitable contributions, along with the total amount of federally itemized deductions — other than deductions for state and local income taxes — for medical and dental expenses and charitable contributions deducted from federal adjusted gross income for the taxable year. Because the IRC § 199A deduction is not included in the standard or itemized deduction under the IRC, the deduction is not permitted for Vermont personal income tax purposes. |
WA |
N/A |
WI |
No. Wisconsin personal income tax calculation starts with federal adjusted gross income, as determined under the IRC as amended and in effect on December 31, 2017, but its IRC conformity statute specifically decouples from IRC § 199A. Further, under current state law, the IRC § 199A deduction would not be permitted even in the absence of such statutory language. Wisconsin allows individual taxpayers to take either a standard deduction or an itemized deduction credit, which is based on the amounts allowed as itemized deductions under the IRC and, therefore, does not include the IRC § 199A deduction. |
WV |
No. West Virginia's personal income tax calculation starts with federal adjusted gross income, and the IRC § 199A deduction is not a permitted deduction. |
WY |
N/A |
This information was last updated on 02/14/2024.
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