What is Pass Through Entity Tax? Latest Guide 2025

A Pass Through Entity—also known as Flow-Through Entity—is a business structure where the entity does not pay income tax itself. Instead, the income, deductions, credits, and other tax items “flow through” to the individual owners, partners, or shareholders, who report them on their personal tax returns.

This structure is common for small businesses, partnerships, LLCs, and S corporations in the United States and is favored for its tax efficiency and simplicity compared to traditional corporations.

How Does Flow Through / Pass Through Entity Tax Work?

When a business is classified for tax as a pass through entity, it:

• Avoids double taxation (unlike C corporations)
• Has no corporate income tax
• Passes income, deductions, credits, and losses to the owners
• Reports this info on a Schedule K-1, Form W-2, or Schedule C (depending on entity type)

Each owner then:

• Includes the income/loss on Form 1040
• Pays taxes at individual income tax rates
• May owe self-employment tax (in some cases)

Entities That Use Pass Through / Flow Through Taxation

Entity Type	Tax Form	Owner Filing
Sole Proprietorship	Schedule C (Form 1040)	Personal return (Form 1040)
Single-Member LLC	Schedule C (Form 1040)	Personal return (Form 1040)
Partnership	Form 1065 + K-1	Form 1040 + Schedule E
Multi-Member LLC	Form 1065 + K-1	Form 1040 + Schedule E
S Corporation	Form 1120S + K-1	Form 1040 + Schedule E
Certain Trusts & Estates	Form 1041 + K-1	Form 1040 (for beneficiaries)

Benefits of Pass-Through / Flow-Through Taxation

1. No Double Taxation

C corporations pay tax on profits and owners pay tax on dividends. With pass-throughs, only the owner pays.

2. Business Loss Deductions

Owners can often deduct business losses against other income (subject to IRS limitations).

3. Potential 20% QBI Deduction (Section 199A)

Many pass-through owners can deduct up to 20% of qualified business income (QBI) from their taxable income.

4. Simplicity

Filing requirements are often less burdensome compared to C corps.

5. Flexibility in Income Allocation

Partnerships, in particular, can structure profit and loss allocations in custom ways (within limits).

Drawbacks and Considerations in Pass Through Entity

1. Self-Employment Tax

Sole proprietors, partners, and LLC members typically pay both the employer and employee portions of Social Security and Medicare taxes.

2. QBI Limitations

Sole proprietors, partners, and LLC members typically pay both the employer and employee portions of Social Security and Medicare taxes.

3. All Income Is Taxed Whether Distributed or Not

Owners must pay tax on their share of business income, even if they don’t actually receive a distribution.

4. Complexity in Multi-Member Structures

Partnerships and S corps must issue K-1s, track basis, and handle capital accounts properly.

Pass-Through Entities vs. C Corporations: A Descriptive Comparison

Understanding the key differences between pass-through taxation and corporate taxation is essential for anyone starting or managing a business in the U.S. Here’s a breakdown of how these two business structures compare across major aspects:

1. Taxation Structure

Pass-Through Entities

• Income is not taxed at the business level.
• Instead, business income, deductions, credits, and losses are “passed through” to the owners (or members/partners/shareholders).
• Owners report this income on their individual tax returns and pay taxes at their personal income tax rates.
• Eligible for the Qualified Business Income (QBI) deduction (up to 20% of net business income, subject to IRS rules).

C Corporation

• The business is treated as a separate legal tax entity.
• It pays corporate income tax on its profits (currently at a flat 21% federal rate).
• If the corporation distributes profits to shareholders as dividends, shareholders also pay tax on those dividends—this results in double taxation.

2. Entity Types and Flexibility

Pass-Through Entities

• Includes sole proprietorships, partnerships, S corporations, and most LLCs.
• Often more flexible in structure and management.
• Easy to form and operate, especially for small businesses or freelancers.

C Corporation

• Suitable for larger businesses or startups seeking outside investment.
• Can issue multiple classes of stock and raise capital through shareholders.
• Required to adhere to formal corporate governance (board of directors, bylaws, annual meetings).

3. Compliance and Formalities

Pass-Through Entities

• Generally faces fewer compliance requirements.
• Less paperwork and simpler annual filings.
• LLCs and partnerships often have relaxed operational rules compared to corporations.

C Corporation

• Must follow strict regulatory and reporting requirements.
• Required to file Form 1120 and maintain corporate formalities.
• May need legal and accounting support to remain compliant.

4. Profit Distribution and Taxation Timing

Pass-Through Entities

• Owners are taxed on their share of profits, even if those profits aren’t actually distributed.
• No “corporate-level” decision is needed to distribute funds; income flows automatically to owners.

C Corporation

• Profits are not taxed to owners until dividends are paid.
• Allows for retained earnings to be reinvested without immediate personal tax consequences.
• Can strategically manage distributions for tax planning.

5. Best Use Cases

Pass-Through Entities

• Ideal for small to medium-sized businesses, freelancers, consultants, and professional service firms.
• Best for owners looking for simplicity and direct tax reporting.

C Corporation

• Ideal for businesses planning to seek venture capital, go public, or issue stock options.
• Better suited for reinvesting profits or operating at scale with multiple investors.

Summary: Key Differences at a Glance

Feature	Pass-Through Entity	C Corporation
Taxation	Single layer (individual level)	Double taxation (corporate + dividends)
Tax Rate	Personal income tax rates	21% corporate tax rate
QBI Deduction	Yes (up to 20%)	Not eligible
Formalities	Fewer legal requirements	Strict governance required
Profit Retention	Taxed to owner whether or not distributed	Not taxed to owner until dividends paid
Best For	Small businesses, LLCs, professionals	Startups, high-growth companies, investors

Example: How Pass Through Taxation Works?

Scenario:

• You’re a 50% partner in an LLC
• The LLC made $100,000 in profit in 2024
• You received no actual distributions

Tax Impact:

• You’ll still report $50,000 on your 1040 via a Schedule K-1
• You pay income tax (and possibly self-employment tax) even though you didn’t receive cash

Pass Through Deductions Explained

Pass through deductions refer to tax benefits available to owners of pass-through entities—businesses where income is not taxed at the corporate level, but instead flows through to the owners’ individual tax returns. The most well-known and valuable deduction in this space is the Qualified Business Income (QBI) deduction, also known as the Section 199A deduction.

What Is the Pass Through Deduction?

Under the Tax Cuts and Jobs Act (TCJA) of 2017, owners of pass through businesses can deduct up to 20% of their qualified business income (QBI) from their taxable income.

This deduction is available through 2025, unless Congress extends or modifies the law.

Who Can Claim the Pass Through Deduction?

The pass-through deduction—also known as the Qualified Business Income (QBI) deduction under Section 199A—can be claimed by individuals with income from eligible pass-through businesses. These include:

• Sole proprietorship
• Partnership
• LLC (single or multi-member)
• S Corporation
• Certain trusts and estates

Note: C corporations do not qualify for this deduction.

Qualified Business Income (QBI) Pass Through Entity Reporting: What Counts?

What is Qualified Business Income (QBI)?

QBI is the net amount of qualified income, gain, deduction, and loss from a qualified trade or business.

It generally includes:

• Business profits from sole proprietorships
• Partnership income (from K-1s)
• S-corporation income (from K-1s)
• Certain REIT dividends and publicly traded partnership (PTP) income

It does NOT include:

• Wages or guaranteed payments to partners
• Capital gains or losses
• Dividend income
• Interest income not properly allocable to the business
• Income from C-corporations

What is the QBI Deduction?

The QBI deduction (also called the Section 199A deduction) allows eligible taxpayers to deduct up to 20% of their qualified business income on their federal income tax return.

Who Qualifies for the QBI Deduction?

You may qualify if you:

• Have income from a U.S.-based qualified trade or business (as a sole proprietor, partner, S-corp shareholder, or LLC member)
• Fall within the income thresholds (adjusted annually)

For 2024 (filing in 2025):

• Full deduction if taxable income is below:
  • $191,950 (Single)
  • $383,900 (Married Filing Jointly)

If your income is above these limits, the deduction may be limited or phased out based on the type of business and whether it is a Specified Service Trade or Business (SSTB) (e.g., law, health, consulting, etc.).

Income Thresholds & Limitations (2025 Updates)

The pass through deduction has income limits:

Filing Status	QBI Deduction Phase-Out Begins
Single	$191,950
Married Filing Jointly	$383,900

If your taxable income is below these thresholds, you can usually claim the full 20% deduction.

If your income is above, the deduction:

• May be limited or phased out
• Depends on whether your business is a Specified Service Trade or Business (SSTB)
• May require W-2 wage & property tests

What Is a Specified Service Trade or Business (SSTB)?

An SSTB (Specified Service Trade or Business) refers to businesses where the principal asset is the skill or reputation of one or more of its owners or employees. These include professions such as doctors, lawyers, accountants, consultants, investment managers, and more.

These are businesses where the principal asset is the reputation or skill of the owner(s). Includes:

• Law
• Accounting
• Consulting
• Financial services
• Health services
• Performing arts
• Athletes

If you’re in one of these fields and your income exceeds the threshold, your deduction may be reduced or eliminated.

While SSTBs face limitations on the QBI deduction at higher income levels, they offer several strategic and financial benefits that make them highly valuable and attractive business models.

Benefits Of Specified Service Trade or Business (SSTB)

1. High Profit Margins

SSTBs typically operate in knowledge-based industries, where the cost of delivering services is relatively low compared to the value provided.

• No inventory or manufacturing costs
• Lower overhead in many cases (especially for digital or advisory services)
• Revenue is primarily tied to professional time, expertise, or reputation

Example: A consultant may earn $250,000 a year with minimal fixed costs, resulting in a high net profit.

2. Low Capital Requirements

Unlike manufacturing or retail businesses, SSTBs generally do not require significant capital investment in equipment, property, or inventory. This makes them easier to start, scale, and sustain.

• Start-up costs are minimal (e.g., laptop, internet, website)
• Business can often operate remotely or with a small team
• Easier to enter and exit the market

3. Reputation-Based Growth Potential

SSTBs benefit from personal branding and referrals, which can lead to exponential growth without proportional increases in expenses.

• Professionals can charge premium rates as credibility grows
• Expertise and reputation become a long-term business asset
• Strong client relationships drive repeat business and word-of-mouth marketing

4. Flexibility and Autonomy

Most SSTBs are service-driven, allowing owners a great deal of flexibility in how, when, and where they work.

• Freedom to set your own schedule
• Ability to serve clients nationwide or globally
• Often ideal for freelancers, consultants, and remote professionals

5. Eligibility for Pass-Through Taxation

Even though SSTBs face QBI deduction limitations at higher income levels, they still benefit from pass-through taxation, which means:

• No corporate tax at the business level
• Income is reported on the owner’s personal tax return
• Potential for simplified tax filing and avoidance of double taxation (unlike C corporations)

6. Professional Licensure Creates Market Barriers

Many SSTBs (such as law or medical practices) require licensing or certifications, which:

• Protects the industry from oversaturation
• Ensures a steady demand for qualified professionals
• Gives credentialed business owners a competitive edge

7. Long-Term Stability and Demand

Services provided by SSTBs are often recession-resistant and consistently needed, such as:

• Legal services
• Financial planning
• Healthcare and counseling
• Tax and accounting services

This ensures long-term client retention and income stability, even in volatile markets.

8. Scalability Through Knowledge-Based Models

SSTBs can scale their income without proportionally increasing costs by:

• Offering group-based services (e.g., coaching, webinars)
• Creating digital products or online courses
• Building teams or hiring junior professionals under their brand

Calculating the Pass-Through Deduction

There are two main limitations on the QBI deduction for high earners:

1. Wage & Property Test (for non-SSTBs above the threshold):

Your QBI deduction is the lesser of:

• 20% of QBI
  OR
• The greater of:
  • 50% of W-2 wages paid by the business
  • 25% of W-2 wages + 2.5% of unadjusted basis of business property

2. Overall Limitation

The deduction cannot exceed 20% of your taxable income minus capital gains.

Example Scenario

Let’s say:

• You’re a sole proprietor in a non-SSTB
• Net business income (QBI) = $120,000
• You’re single with total taxable income = $150,000

Calculation:

• QBI Deduction = 20% of $120,000 = $24,000
• Taxable income reduced to $126,000

Now you’re taxed only on $126,000 rather than $150,000!

Things That Reduce Your QBI

• One-half of self-employment tax
• SEP/SIMPLE/Qualified retirement contributions
• Self-employed health insurance deduction
• Domestic production activities deduction (if applicable)

How to Maximize Your Pass-Through Deduction

Maximizing pass-through deductions—particularly the Qualified Business Income (QBI) deduction under Section 199A—requires strategic tax planning. While pass-through entities like sole proprietorships, partnerships, S corporations, and LLCs offer attractive tax benefits, careful management of income, expenses, and structure can significantly impact how much you actually save.

Here’s a descriptive guide on how to maximize pass-through deductions:

How to Maximize Pass-Through Deductions (Including QBI)

1. Keep Taxable Income Below the QBI Threshold

One of the simplest ways to ensure you qualify for the full 20% QBI deduction is to keep your taxable income under the IRS threshold:

• Single filers: $191,950
• Married filing jointly: $383,900
  (For tax year 2024, filed in 2025)

Strategies:

• Make retirement plan contributions (e.g., SEP IRA, Solo 401(k))
• Contribute to Health Savings Accounts (HSAs)
• Claim all available business deductions and above-the-line adjustments (like student loan interest, self-employed health insurance)

2. Optimize Business Expenses

Every dollar you deduct as a legitimate business expense reduces your net business income, which is the basis for calculating the QBI deduction.
However, over-deducting may reduce your QBI so much that the 20% deduction becomes minimal.

Strategies:

• Track and claim home office, vehicle, supplies, utilities, and software expenses
• Ensure expenses are ordinary and necessary per IRS rules
• Review annual expenditures with a tax advisor to balance deductions with overall QBI optimization

3. Evaluate Your Business Entity Structure

Your entity type impacts how QBI is calculated and how much income flows through to your return.

Examples:

• S Corporations can reduce self-employment tax by paying a “reasonable salary” and treating the remaining profit as a distribution—potentially increasing QBI while reducing payroll tax.
• LLCs taxed as partnerships offer flexibility but require planning to maximize QBI eligibility.

Restructuring your business may be beneficial as income levels grow or tax laws change.

4. Manage W-2 Wages and Qualified Property

If your income exceeds the QBI threshold, you must pass the W-2 wages and qualified property test:

• You can deduct up to 20% of QBI, but not more than:
  • 50% of W-2 wages paid, or
  • 25% of W-2 wages + 2.5% of unadjusted basis of qualified property

Strategies:

• Increase W-2 wages by hiring employees or raising salaries to meet deduction tests
• Purchase qualified property (like machinery or buildings) and hold it, as its original cost (not depreciation) supports your deduction
• Avoid overpaying wages, which could reduce QBI

5. Avoid SSTB Limitations (if Possible)

Specified Service Trades or Businesses (SSTBs) like doctors, lawyers, consultants, and financial advisors face phase-outs or elimination of the QBI deduction when over the income threshold.

Strategies:

• Create a separate business entity for non-SSTB activities (e.g., licensing intellectual property, renting office space)
• Allocate expenses carefully to avoid full SSTB classification
• Use cost segregation for real estate to boost depreciation while preserving QBI

6. Aggregate Businesses (When Applicable)

If you own multiple pass-through businesses, the IRS allows you to aggregate them (combine QBI, W-2 wages, and property amounts) if certain conditions are met. This can:

• Improve the wage/property test outcome
• Increase your total QBI deduction

Requirements:

• Common ownership (50% or more)
• Related industries or operations
• Use of similar methods and management

7. Work with a Tax Advisor Year-Round

The QBI deduction rules are complex and affected by multiple factors. A qualified tax professional can:

• Run simulations
• Analyze salary vs. distributions
• Help with entity restructuring
• Track thresholds and phase-outs

Summary: Key Tips to Maximize QBI Deduction

Strategy	Impact
Stay below taxable income limits	Full 20% deduction
Track and optimize expenses	Reduces net income and tax burden
Use the right entity type	Can increase QBI or reduce SE tax
Pay W-2 wages strategically	Helps meet QBI wage test
Aggregate multiple businesses	Boosts QBI or deduction limits
Use property investments wisely	Strengthens property-based QBI limits
Avoid SSTB classification (if applicable)	Preserves eligibility

IRS Forms You’ll Need

Form	Purpose
Form 1040	Individual tax return
Schedule C	For sole proprietors and single-member LLCs
Form 1065	Partnership tax return
Schedule K-1	Shows partner/shareholder’s share of QBI
Form 1120S	S Corporation tax return
Form 8995 / 8995-A	Used to calculate the QBI deduction

IRS Forms Used in Pass-Through Taxation

Form	Used For
Form 1065	Partnership and multi-member LLC returns
Schedule K-1	Reports each owner’s share of income/loss
Form 1120S	S corporation income tax return
Schedule C	Sole proprietors and single-member LLCs
Form 1040	Personal tax return where income is reported