Pass-through entity: How it works, types [+ which to pick]

There is no limit to how much you can earn within a pass-through entity, but there is a taxable income limit for the Qualified Business Income (QBI) deduction, which is $394,200 for those married filing jointly and $197,300 for all others for tax year 2025. 

Types of pass-through entities

There are a few ways to set up a pass-through entity, and all accomplish the same purpose of avoiding double taxation. However, depending on the type of operation you run, one business structure may benefit you more than another. The types of pass-through entities include LLCs, S-corps, partnerships, and sole proprietorships.

While LLCs, S-corps, and partnerships are all separate business structures, they all pass profits and losses directly to the owners. Learn more about the differences between an S-corp and an LLC.

LLC

LLCs provide owners (also known as members) with limited liability. However, they are less susceptible to strict compliance requirements than a corporation. 

LLCs offer flexibility with taxation, where you can elect pass-through or corporation taxation. Note that the default taxation for single-member LLCs, a popular option for solopreneurs, is the same as sole proprietorships. 

For example, assume Bob owns a gift shop as an LLC. The gift shop’s profits and losses pass through to Bob’s personal tax return. Bob would list his LLC’s profits and losses on Schedule C, which he’ll attach to his 1040 form. 

S-corp

An S-corp is not a business entity type but a tax election that LLCs or corporations can make with the IRS. An S-corp’s income taxes flow through to its owners. 

For example, if Bob’s gift shop elects S-corp taxation, he would file Form 1120-S as an information tax return. He would pay no corporate income tax, and the income would flow through to his personal tax return. 

Partnerships

With partnerships, you divide the business income among the owners. The partnership files an information return, Form 1065, and sends each partner a Schedule K-1. The K-1 will report each partner’s share of business profits. 

If Bob’s gift shop operates as a partnership, he would need to file Form 1065 as an information tax return. He would pay no corporate income tax, the income flowing through to the partners.

Note that the IRS treats multimember LLCs like partnerships for tax purposes. 

Sole proprietorship

With a sole proprietorship, there is no separation between you and your business. This is the default business structure unless you file for a different one. A sole proprietorship is best for individuals who need simplicity and don't mind being personally liable for any risks. 

For example, if Bob owns a gift shop as a sole proprietor, he would report the profits and losses on Schedule C of his personal tax return. Bob would add the business profit from Schedule C to his other income and then calculate the income tax at his personal tax rate.

Self-employment taxes for pass-through entities

When you're the owner of a pass-through entity, you're responsible for paying self-employment taxes, which cover Social Security and Medicare.  

These taxes are calculated on your net earnings from the business and are in addition to your regular income tax. 

The current self-employment tax rate is 15.3%:

• 12.4% for Social Security 
• 2.9% for Medicare

It's important to factor these taxes into your financial planning when considering a pass-through entity structure. 84% of respondents in the 2025 Entrepreneurship Study who own businesses say they’re confident they’ll file their business taxes correctly this year. However, less than half (49%) say they’re very confident. 

State-level pass-through taxes

Some states impose a pass-through entity (PTE) tax at the state level. For example, Maryland applies an 8.25% PTE tax. Always check your state’s rules, since rates and filing requirements vary.

What is a qualified business deduction? 

The qualified business income (QBI) deduction, introduced by Section 199A of the Tax Cuts and Jobs Act, allows eligible self-employed individuals and owners of pass-through entities to deduct up to 20% of their qualified business income. This deduction can significantly reduce your taxable income and overall tax liability. 

This deduction is a major incentive for structuring your business as a pass-through entity, but it's important to understand the benefits and pitfalls first to maximize its benefits.

What are the benefits of pass-through entities?

While it’s true that pass-through entities may look like an easy choice when selecting a business structure, there are a few things to consider before making a decision. 

To start, here are three key advantages of a pass-through entity:

• Avoids double taxation: The major benefit is that these entities avoid double taxation, where dividends are not tax-deductible. However, individuals receiving income from pass-through entities only pay taxes once. 
• Allows for a tax deduction: Operating your business as a pass-through entity allows you to take the QBI deduction via Section 199A. 
• Easy to form: Some pass-through entities, like sole proprietorships, do not require registration paperwork. You can start an LLC by filing articles of organization with your state. 

Ultimately, the best way to determine if a pass-through entity is right for you is to weigh these advantages against your specific business needs and goals.

What are the pitfalls of pass-through entities? 

Though pass-through entities offer significant tax advantages and simplicity, it's crucial to understand the potential drawbacks before deciding.

Pass-through entities also come with disadvantages:

• Pay taxes on all income: Owners of pass-through entities pay taxes on all income—even the portions that went straight back into the business. 
• More liability: Business owners of some pass-through entities may lack legal separation between owners and the business. 
• More difficult to attract investors: Many investors will only invest in a corporation structure, limiting the capital-raising options that pass-through entities have. 

The advantages and disadvantages of pass-through entities are a great starting point for figuring out if one of the structures works for you. However, if you need personalized guidance, consider consulting a tax professional.

How to choose the right pass-through entity

Picking the best business structure is about aligning your tax savings with your overall business goals. The right entity can lower your tax bill, protect your personal assets, and give you flexibility as your business grows. Here are three key factors to consider when choosing a pass-through entity.

Consider your income level

If your business earns a modest income, a sole proprietorship or single-member LLC may keep things simple and affordable. But as profits rise, you might save more by electing S-corp status, since only your salary is subject to self-employment tax. 

For example, if you earn $120,000 in profit, paying yourself a reasonable $80,000 salary and taking $40,000 as a distribution could save you in self-employment taxes.

Think about liability protection

Sole proprietorships don’t provide a legal shield between your personal and business assets, which means your personal savings, car, or home could be at risk if your business is sued. LLCs and S-corps both offer limited liability protection, helping keep your personal assets separate from your business obligations. 

If protecting your personal wealth is a priority, avoid operating as a sole proprietor.

Look at long-term growth plans

Your choice of entity also affects how easily you can raise money, add partners, or expand into new markets. Sole proprietorships are best for solopreneurs who don’t plan to bring in outside investors. Partnerships and LLCs are more flexible if you want multiple owners. 

If you plan to scale quickly or pay yourself a structured salary, an S-corp may be the most tax-efficient option.

Find peace of mind come tax time

Choosing the right business structure isn’t just about taxes—it’s about protecting your assets, planning for growth, and minimizing stress come filing season. With 2026 tax law changes on the horizon, now is the time to review whether your current structure still serves you best. 

And no matter which entity you choose, accounting software can help you stay organized, separate business from personal expenses, and simplify tax reporting. That way, you’ll have more confidence in your numbers and more time to focus on running your business.

Pass-through entities are a viable option when structuring your business, and how you handle business transactions is important to their success. 

Consider using accounting software to separate and organize your business transactions. Staying up to date throughout the year can save you hours of hassle during tax season—leaving you with more time to focus on running and growing your business.