What Is a Pass-Through Entity?

Pass-Through Entity Explained in 4 Minutes

Definition
A pass-through entity, also called a flow-through entity, is a type of business structure used to avoid double taxation.
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A pass-through entity, also called a flow-through entity, is a type of business structure used to avoid double taxation. Typically, businesses are subject to corporate tax while business owners also have to pay a personal income tax. To avoid this, a company may be registered as a pass-through entity so that the revenue earned is taxed as personal income and no separate business tax has to be paid. 

If you’re a small business owner considering the possibility of setting up a pass-through entity, learn more about what they are, how they work, how they are taxed, and how one might benefit you. 

Definition and Examples of a Pass-Through Entity


A pass-through entity is a business structure in which the taxes on the generated business revenue are directly passed on to the owners, to avoid double taxation. Through this arrangement, business owners and shareholders only pay taxes on their personal income generated through this business and don’t have to pay additional corporate taxes for running the company.

Note

As of Tax Year 2015, in the most recent data made available by the IRS, 95% of businesses were pass-through entities, which have steadily increased since 1980.


Common examples of pass-through entities include sole proprietorships, partnerships, limited liability companies, and S-corporations. We’ll explore each of these in detail below. 


Alternate name: Flow-through entities

How a Pass-Through Entity Works 

Earned money is usually taxable. Individuals pay personal income tax on their salaries and businesses pay corporate tax based on the revenue the organization generates during a financial year. 

Unfortunately, this means business owners can face double taxation that forces them to pay a personal income tax on the money they make through their business and also pay a corporate tax under the business’s name. To avoid this, a large majority of businesses register as pass-through or flow-through entities. 

Under these, the income generated is considered solely the income of the investors, stockholders, or owners. Therefore, the earnings and the taxes directly pass or flow through to the individuals. Because the earnings are now taxed as personal income, the usual personal income tax rates apply and businesses can avoid paying hefty corporate tax rates.

However, not every pass-through entity works the same way. Each type has different tax rules, as we’ll see below. 

Types of Pass-Through Entities 


The best part about running a pass-through entity is that business owners have a wide variety of options to choose from. 

Note

Each type of pass-through entity has its own advantages and disadvantages, so it’s best to conduct thorough research before making a decision for your business.

Here are the four types of pass-through entities to help you explore the reasons why you should or shouldn't choose each one. 

Sole Proprietorships

Sole proprietorships are among the most common types of pass-through entities, as they are the default option for most independent contractors or freelancers. Sole proprietorships are single-owner businesses and tend to be easier to set up. However, such businesses also have fewer legal and financial protections. 

Pass-through entities registered as sole proprietorships calculate taxes on Schedule C of Form 1040.

This type of pass-through entity is suitable if you’re a new business owner just getting started by yourself. You can switch to another model once you start hiring employees or partner with other individuals and organizations. 

Partnerships

Small businesses bigger than sole proprietorships are typically registered as partnerships. These are companies owned by two or more people and they need formal registration with legal ownership percentages. Partnership businesses file an entity-level tax through Form 1065.

Note

The owners in the partnership model are subject to the federal Self-Employed Contributions Act (SECA) tax levied on those who work for themselves.

Choose a partnership structure if your business has multiple owners but isn’t large enough to be a corporation. 

Limited Liability Companies (LLCs)

Limited liability companies (LLCs) are divided into two types: single-member LLCs and multi-member LLCs. Single-member LLCs are taxed similar to sole proprietorships, while multi-member LLCs are taxed as partnerships. Members in single-member LLCs pay a personal income tax; partners in multi-member LLCs fill out Schedule K-1, which shows their share of the business profits on Form 1065.

S Corporations

Businesses that choose this status file corporate tax through Form 1120S; however, the profits are directly passed on to the owners and shareholders to be reported on Schedule E of Form 1040. Owners aren’t required to pay SECA tax on their profits but need to pay “reasonable compensation,” which is taxed under the Federal Insurance Contributions Act (FICA).

Each type of pass-through entity has something different to offer, depending on your current business model and future goals. If you’re unsure about which business structure is right for you, speak with a legal or accounting expert.

Key Takeaways

  • Pass-through entities, also called flow-through entities, are business structures used by the vast majority (95%) of U.S. companies to avoid double taxation.
  • In these models, the taxes pass or flow through directly to the owners, rather than the company.  
  • Pass-through entities typically include sole proprietorships, partnerships, limited liability companies, and S-corporations. 
  • Each type has different taxation rules, depending on the business model chosen. 
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Tax Policy Center. “What Are Pass-Through Businesses?” Accessed Feb. 1, 2022.

  2. EconoFact. “The Other 95%: Taxes on Pass-Through Businesses.” Accessed Feb. 1, 2022.

  3. Brookings Institution. “9 Facts About Pass-Through Businesses.” Accessed Feb. 1, 2022.

  4. Tax Foundation. “Pass-Through Businesses Q&A.” Accessed Feb. 1, 2022.

  5. IRS. “Tax Information for Partnerships.” Accessed Feb. 1, 2022.

  6. Social Security Administration. “What Are FICA and SECA Taxes?” Accessed Feb. 1, 2022.

  7. IRS. “LLC Filing as a Corporation or Partnership.” Accessed Feb. 1, 2022.

  8. U.S. Small Business Administration. “Small Business Owners Tax Workshop Part 1,” Pages 10 and 12. Accessed Feb. 1, 2022.

  9. U.S. Treasury Department. “Gaps Between the Net Investment Income Tax Base and the Employment Tax Base,” Page 2. Accessed Feb. 1, 2022.

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