The business structure of an organization determines the amount of tax it pays. With the right structure, you can lower your financial burden to a large extent. For many small businesses and entrepreneurs, a pass-through entity has become a preferred way to save on taxes.
In this article, we will do a complete deep dive into a pass-through entity, its advantages and risks, and how you can set one up with expert help.
Pass-Through Entity Meaning: A Simple Definition
Let’s start by understanding what is a pass-through entity.
What “Pass-Through” Means in U.S. Tax Law
A pass-through entity, as the name suggests, is an entity that passes the profits directly to the owners. As a result, the profits are taxed at the individual rate, which is far lower than the federal income tax rate for businesses.
Also known as a flow-through entity, it is an attractive option for small businesses because the owners can avoid double taxation, once for the company and once for the owner. Instead, everything is taxed only at the individual tax rate.
How It Differs from Traditional Corporations
A C-corporation is a traditional business structure in the U.S. It files its own income tax at the federal corporate rate. If it pays owners dividends, then these dividends are also taxable for the owners.
Individual vs. Business-Level Taxation
As you can see, this creates two layers of tax – one is the corporate tax and the other is the tax on dividends. In a pass-through entity, all the profits are sent to the owners, who pay only a single tax at the individual income tax rate. There are no corporate taxes.
Types of Pass-Through Entities in the U.S.
In the U.S., about half of the businesses that are not C-Corporations are pass-through entities. This includes sole proprietorships, LLCs, and S-Corporations.
Let’s take a brief look at each of these business entities.
Sole Proprietorship
A sole proprietorship is the simplest form of business structure, as it consists of the owner only. There is no separation between the owner and the company, and the profits are reported as the owner’s income under Schedule C. Also, the owner is responsible for all debts and liabilities. This business structure is well-suited for freelancers, contractors, and home-based businesses.
Partnership (General and Limited)
A partnership is a formal agreement between two or more people, where the responsibilities of each are laid down under the contract. There are two kinds of partnerships, namely, general and limited.
A general partnership is one where all the profits and losses are shared equally among all the partners, based on the partnership agreement. On the other hand, in a limited partnership, the profit sharing, capital, and operations are governed by a formal deed. In this type of partnership, one or more partners may take responsibility for the organization’s operations and may also choose to bear the losses. The limited partners only invest, but have no role in the operations.
Partnerships are also treated as pass-through entities, and the business has to file Form 1065 for itself, and a Schedule K-1 is sent for each partner. This business structure is a good choice for professional consulting companies, law firms, and family businesses.
Limited Liability Company (LLC)
The LLC business structure combines the pass-through taxation of a sole proprietorship or partnership with the limited liability of a corporation. If the LLC has only a single member, then it is treated as a sole proprietorship, and the income is added to the Schedule C of the member’s income tax.
On the other hand, if the LLC has multiple members, then it is treated as a partnership, and each partner receives the Schedule K-1 that details the income they received. Additionally, the firm has to file Form 1065. Along with these taxation benefits, all members enjoy limited liability.
S-Corporation (S-Corp)
An S-Corp is a special tax status that partnerships and LLCs can elect, but it is not a legal entity type. LLCs can elect S-Corp status by filing Form 2553 with the IRS. Partnerships must first convert to an eligible entity type before making this election. If partnerships and LLCs want to elect the S-Corp status, all the shareholders must sign Form 2553 and file it with the IRS. If you’re unsure of this form, Manay CPA can explain the benefits of an S-Corp, and will even file the Form 2553 for you.
S-Corp is eligible for pass-through entity status. It has to file Form 1120-S, while the owners will get Schedule K-1, as discussed above.
However, to qualify for an S-Corp, an entity must meet the following requirements:
- It must be a domestic corporation.
- The shareholders must be individuals, estates, and certain trusts only. It cannot have partnerships, corporations, or non-resident aliens as its shareholders.
- The S-Corp cannot have more than 100 shareholders.
- Only one class of stock is allowed.
- This status is not given to financial institutions, insurance companies, or domestic or international sales corporations.
Due to these restrictions, S-Corp works best for business owners who want to split their income between salary and profit distributions to avoid self-employment taxes.
Professional Entities (PLLC, LLP)
Some professions, like doctors, lawyers, and accountants, must form professional entities. They can be a Professional Limited Liability Company (PLLC) or a Limited Liability Partnership (LLP). These entities receive similar pass-through tax treatment as LLCs, and they offer limited liability protection against business debts.
How Pass-Through Entities Are Taxed
Pass-through entities provide many taxation benefits. In particular, it avoids the double taxation of a federal income tax for the entity and individual income tax for owners. However, to enjoy these benefits, every entity must file the appropriate form and follow the respective filing requirements.
Let’s see this process for every entity type.
Schedule C (Sole Proprietors and Single-Member LLCs)
Sole proprietors and LLCs with only a single member must file income under Schedule C (Profit or Loss from Business). This Schedule C must be attached to their Form 1040. Other than this, no other business tax return is required.
At the same time, note that all income is treated as personal income and hence, it is subject to self-employment taxes like Medicare and Social Security tax.
Form 1065 and Schedule K-1 (Partnerships and Multi-Member LLCs)
Partnerships and multi-member LLCs must file Form 1065 with the IRS. This form contains the profits and losses from the business and reports the income, deductions, and overall financial activity of the business. In addition to this, every partner receives a Schedule K-1 that details their share of profit and loss from the business.
The income reported in Schedule K-1 must be included in Form 1040, which the individual partner files with the IRS. Note that by filing Form 1065, the firm does not have to pay the federal income tax.
Form 1120-S (S-Corps)
S-Corp, as discussed above, is a tax structure and not a separate legal entity. It files Form 1120-S to report business income, which passes through to shareholders for taxation at the individual level. Like partnerships, every shareholder also receives a Schedule K-1
Additionally, owners must receive a salary that is subject to payroll taxes. The salary must be reasonable, in accordance with IRS guidelines. To ensure that you meet the legal compliance requirements, reach out to the experts at Manay CPA, who can provide the right balance for you.
Self-Employment Taxes
Sole proprietors and single-member LLC owners pay SE tax on all net earnings from the business (reported on Schedule C). S-Corp owners, on the other hand, pay payroll taxes only on their reasonable salary; distributions from the S-Corp are not subject to SE tax. In 2025, the self-employment tax rate is 15.3% on the net earnings. For S-Corp owners, this tax applies only to their reasonable salary, not to profit distributions
Qualified Business Income (QBI) Deduction – IRC 199A
Qualified Business Income (QBI) deduction was introduced by the 2017 Tax Cuts and Jobs Act. As per the provisions of this Act, business owners who receive pass-through profits from the business entity can claim up to a 20% deduction on their qualified business income. However, it is available only for those whose taxable income is below $483,900 for married filing jointly and $241,950 for other filers.
Overall, the taxes are reduced greatly when owners get money from pass-through entities.
Benefits of Pass-Through Taxation
As a business owner, you can get many taxation and administrative benefits with the pass-through taxation option. Below are some of the important benefits.
Avoidance of Double Taxation
In a traditional C-Corporation, profits are taxed twice. The entity must pay a federal income tax on the profits, and the business owners must pay taxes on their share. To avoid this double taxation, the idea of pass-through entities came into force. Under this process, the profits are passed to owners, who in turn, pay taxes on this income. No corporate tax is paid.
Simpler Filing for Small Business Owners
Since entities pass on the profits to owners, they have fewer filings than C-Corps. Sole proprietors and single-member LLCs do not need to file separate business returns. However, partnerships, multi-member LLCs, and S-Corps must file informational or corporate tax forms. While pass-throughs may have simpler filing than C-Corps, tax planning is still recommended, especially for entities with multiple owners.
For owners, all that they have to do is attach the respective Schedules with their Form 1040, and add the profits to the overall income for computing taxes.
Flow-Through of Losses and Credits
With this setup, the losses and credits are also passed on to the owners, who can offset them against their income. This way, they can gain tax benefits, even in the event of a business loss. Similarly, if the business gets any tax credits from the government, those are passed on to the owner, who can reduce the same from their total income. Some examples of tax credits are clean energy investments, R&D, payments to charities, etc.
This flow-through option can be particularly useful for startups that are in the early stages and want to offset their losses.
Flexibility in Income Distribution and Profit Sharing
You can have flexible arrangements with pass-through entities. Specifically, if you elect an S-Corp option, you can split the income between salary and distributions to bring down your taxable income.
Beneficial for International Founders With U.S. LLCs
Pass-through entities are highly beneficial for international founders and entrepreneurs, as they can pass the taxes in their respective countries without worrying about the taxation process in the U.S. Note that this option to pay in the home country depends on the origin of the country and prevailing tax treaties.
Additionally, foreign owners of pass-through entities often need an ITIN to receive a K-1 and file U.S. taxes, even if there’s no tax due.
Manay CPA specializes in helping international entrepreneurs leverage this option.
Limitations and Risks of Pass-Through Entities
Despite the above benefits, pass-through entities also come with certain limitations and risks. As a business owner, it’s important to understand these risks, so you can make an informed decision.
Full Self-Employment Tax Liability
Owners of sole proprietorships and single-member LLCs are responsible for paying self-employment tax on all net income (currently 15.3%). For S-Corp owners, only salaries are subject to payroll taxes.
Not Ideal for Raising Venture Capital
Note that S-Corp entities cannot issue multiple types of shares. Also, it has many restrictions on having members, as discussed above. Due to these reasons, an S-Corp is not the ideal structure for raising venture capital.
Limited Liability Protection May Vary by Structure
The liability protection is not universal, as there is no liability protection for sole proprietors or partnerships.
Potential Complexity in Multi-Member Agreements
Opting for an S-Corp can lead to disputes, especially in partnerships and multi-member LLCs, where each partner can have a different role or contribution.
U.S. Tax Reporting for Foreign-Owned Pass-Through Entities
If you’re a non-U.S. citizen or resident owning a pass-through entity, you must follow the strict IRS rules for filing taxes. Below are the notable aspects to consider.
ITIN/EIN Requirements
Employer Identification Number (EIN) is mandatory for every U.S. entity to start its operations. In particular, it is mandatory for opening a bank account, paying employees, and filing taxes. Though it is simple to apply for an EIN, the application can be submitted online or via a U.S.-based responsible party or agent.
Along with an EIN, the business owner must also apply for an Individual Taxpayer Identification Number (ITIN) if they don’t have a Social Security Number (SSN). If you’re not a U.S. citizen or resident, you can apply for an ITIN using Form W-7.
Form 5472 + 1120 for Foreign-Owned SMLLCs
When a single-member LLC is owned by a foreign owner, it is termed a “disregarded entity.” What this means is that the LLC’s activities will be reflected in the individual’s tax return. At the same time, the foreign owner must file two forms:
- Form 5472 – This form discloses the relationship between the LLC and the owner.
- Form 1120 – This is the form that must be filed along with Form 5472, even if the LLC has not earned any income.
Failure to file Form 5472 can attract a penalty of $25,000 per year.
Withholding Rules for Foreign Members
A non-resident alien or a foreign corporation can consolidate income from all its sources in the U.S. that is connected with the operations of a business. This consolidated income is called the Effectively Connected Income (ECI).
If you choose this option, the U.S. entity must file Form 1042-S to report income distributed to nonresident foreign owners. Also, if income is distributed to foreign partners, then Form 8804/8805 must be filed.
State vs. Federal Taxation
So far, we have seen that companies don’t have to file federal income tax when they become a pass-through entity. However, this doesn’t exempt them from state taxes, especially if the business operates in states like California or New York, which have high taxation rates.
Since the rules vary greatly by each state, it’s best to contact an expert CPA to avoid penalties.
How to Form a Pass-Through Entity (Step by Step)
Starting a pass-through entity involves many legal and taxation processes. Here are the steps involved:
Step 1: Choosing the Right Structure
The first step is to decide which business structure you want to go with. Evaluate different options and select the one that works best for you. In general, go for partnerships and S-Corp if there are two or more people. On the other hand, if you’re a sole owner and want limited liability, go single-member LLC.
Step 2: Selecting the Right State
The choice of state has a big bearing on your tax burden. When you opt for tax-friendly states like Delaware, Texas, Wyoming, Florida, etc, you can save on taxes. That said, taxes must be one of the factors to consider, with some of the others being the availability of talent, the surrounding ecosystem, and the policies of the state.
Step 3: Filing Articles of Organization or Incorporation
Once you decide on the structure and state, it’s time to start the filing process. You must file Articles of Organization for an LLC and Articles of Incorporation for a corporation. File the required documents with the Secretary of State and pay the associated fees.
Step 4: Applying for EIN and ITIN
Every entity must apply for an EIN before it can start operations. It can be applied at the IRS site using Form SS-4. If the owner is a foreign-born without an SSN, the owner must apply for an ITIN as well.
Step 5: Making an S-Corp Election (If Applicable)
If you want to elect to S-Corp, file Form 2553 with the IRS. It must be done within 75 days after starting a tax year or forming the business. It must be signed by all the members.
With these steps, a pass-through entity is all set to begin operations.
How to Choose Between LLC and S-Corp
Should you choose an LLC or an S-Corp? The answer depends on factors like income levels, the need to split between salary and distribution, tax savings potential, and compliance requirements. Let’s dive into each of these factors in detail.
Income Thresholds and Payroll Considerations
LLCs and sole proprietorships don’t offer much of a tax advantage. S-Corp profit distributions are not subject to self-employment tax, unlike wages or sole proprietorship income. Still, there has to be a reasonable salary paid to the owners, so the self-employment taxes go down. In general, S-Corp is efficient when the income exceeds $60,000.
Reasonable Salary
If you’re an S-Corp, owners must get a reasonable salary based on the market rates laid down by the IRS. The salary must be reported, and the payroll taxes must be withheld. Failure to pay a reasonable salary can attract fines.
Compliance Requirements and Ongoing Costs
If you opt for an S-Corp, be prepared to add extra processes like payroll handling, accurate bookkeeping, and federal and state filing. LLC, on the other hand, has more simplified procedures.
Tax Savings Potential Comparison Table
Tax savings through an S-Corp are higher when the owner’s income exceeds $100,000. When the income is less than $40,000, an LLC is a better option, as there is not much benefit, but reduced processing.
Income |
Ideal Tax Structure |
| Less than $40,000 | LLC |
| $40,000 to $100,000 | S-Corp, especially if there’s potential for growth. |
| $100,000 | S-Corp |
Recordkeeping and Reporting Obligations
Pass-through entities have strict recordkeeping and reporting processes to follow. The following are the obligations.
Annual Reports and Franchise Taxes
Many states require LLCs, partnerships, and S-Corps to file state and franchise taxes. Some states also mandate the filing of annual reports, regardless of business activity. Late or missed filing can lead to penalties and even the dissolution of the business.
Bookkeeping Requirements
Some pass-through entities like S-Corps, PLLCs, and even multi-member LLCs have strict bookkeeping requirements. The records must be accurately maintained, and they must continuously track capital contributions and salary vs distribution splits. If the entity is an S-Corp, it must also process payrolls and maintain records of the same.
IRS Deadlines
The deadline for filing individual income tax is April 15th, while it is March 15th for those who issue Schedule K-1s. Meeting these deadlines is critical to avoid penalties.
Working with an Accountant or a CPA
Handling a pass-through entity or converting to an S-Corp can be complex, especially if you don’t live in the United States. Make sure to tap into the services of an accountant or CPA firm like Manay CPA to navigate these tax implications.
Case Studies: Who Should Choose a Pass-Through Entity?
Let’s examine some real-world case studies.
Freelancer in Graphic Design
A freelance graphic designer or any other contractor may not benefit much from a pass-through entity because the profits will be taxed as personal income only. However, forming a single-member LLC can offer limited liability.
Foreign Tech Consultant with U.S. Clients
A foreign tech consultant with U.S. clients may benefit from using a pass-through entity depending on U.S. tax treaty provisions and the source of income rules.
Two-Person Partnership Starting a SaaS Product
Similarly, a two-person partnership starting a SaaS product will benefit from both a pass-through entity and an S-Corp, as they can reduce their payroll taxes.
U.S.-Based Coach Launching Online Courses
A U.S.-based coach selling digital products and online courses can benefit from an S-Corp, provided income exceeds $60,000 per year.
How Manay CPA Helps You Structure and Maintain a Pass-Through Entity
Manay CPA offers end-to-end support for starting and maintaining a pass-through entity. Specifically, it offers the following useful services.
Entity Type Selection and Formation Guidance
One of the first questions is the entity type, and Manay CPA works with you to understand your goals and operations. Accordingly, it offers guidance on entity selection and formation.
EIN and ITIN Applications for U.S. and Foreign Founders
Manay CPA specializes in applying for EIN and ITIN for U.S. and foreign individuals. It is well-versed in the process and can file these forms on your behalf.
Tax Planning & Optimization
As your business grows, Manay CPA can help with tax planning and optimization, so you can keep more of the income you earn. Its bookkeeping and payroll services, coupled with insights from taxation experts, can help optimize your income.
K-1, 1040NR, 5472 Filing & Compliance
Filing forms is time-consuming, but still necessary to avoid penalties from the IRS. Manay CPA can file these different forms before their respective deadlines, so you are always compliant.
Additionally, Manay CPA offers ongoing support and guidance every step of the way.
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