A pass-through entity is a business entity that generally pays no federal income tax at the entity level. Its income, losses, deductions and credits pass instead to its owners, who report their shares on their own returns and pay the tax there. The class covers the sole proprietorship, the partnership, the S corporation, and the limited liability company under whichever of those classifications it takes for federal tax purposes.
The Authority Behind Each Member of the Class
Each member of the class reaches the same result through a different provision.
Partnerships
A partnership as such is not subject to the income tax imposed by chapter 1 of the Code, and persons carrying on business as partners are liable for income tax only in their separate or individual capacities (26 U.S.C. 701).
Section 702 sends the items out. Each partner takes into account separately that partner’s distributive share, meaning the portion of each partnership item allocated to that partner, across categories ending at the partnership’s taxable income or loss exclusive of items requiring separate computation (26 U.S.C. 702(a)).
S Corporations
Except as otherwise provided in its subchapter, an S corporation is not subject to the taxes imposed by chapter 1 (26 U.S.C. 1363(a)). The exceptions that opening phrase preserves are real, and where each one lands on the return is set out in federal income tax liability.
The matching pass-through provision reaches the shareholder. In determining a shareholder’s tax, that shareholder takes into account a pro rata share of the corporation’s items of income, loss, deduction or credit whose separate treatment could affect any shareholder’s tax liability, and of its nonseparately computed income or loss (26 U.S.C. 1366(a)(1)).
Sole Proprietorships and Single-Member LLCs
Neither of those sections reaches a sole proprietorship or a disregarded single-member LLC, because for income tax purposes there is no separate entity left to tax. A business entity with two or more members is classified as either a corporation or a partnership, and one with a single owner is classified as a corporation or is disregarded, in which case its activities are treated in the same manner as a sole proprietorship, branch or division of the owner (26 CFR 301.7701-2(a)). The default that applies without an election, and the elections that override it, are in how to file a business tax return.
Which Return Each One Files
A partnership files an annual information return reporting the income, deductions, gains and losses from its operations, does not pay income tax, and furnishes each partner a copy of Schedule K-1 (Form 1065) to report on a personal return (IRS, Partnerships).
An S corporation files Form 1120-S, and its shareholders report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates (IRS, S corporations).
A sole proprietor and a disregarded single-member LLC have no entity return at all. A sole proprietor reports the income or loss from the business on Schedule C (Form 1040) (IRS, About Schedule C (Form 1040)).
For a disregarded single-member LLC the schedule follows the activity. Its activities are generally reflected on the individual owner’s Schedule C for profit or loss from business, Schedule E for supplemental income or loss, or Schedule F for profit or loss from farming (IRS, Single member limited liability companies).
Income that reaches an owner’s return this way can feed that owner’s deduction for qualified business income under section 199A (26 U.S.C. 199A(a)), set out in QBI deduction, and the dates these returns run on are in IRS business tax filing deadlines.
What Is the Difference Between a Pass-Through Entity and an LLC?
LLC names a state law status and pass-through entity names a federal tax treatment, so the two answer different questions. An LLC is an entity created by state statute, and depending on elections made by the LLC and the number of members, the IRS treats it as a corporation, a partnership, or as part of the owner’s tax return (IRS, Single member limited liability companies).
So an LLC is usually a pass-through entity, but not always. One that elects corporate treatment without an S election pays tax on its own income, the split described in c corp vs s corp.
Pass-Through Entity and Flow-Through Entity
Flow-through is the IRS’s own word for this mechanism. The S corporation page uses that word for what shareholders report on their personal returns (IRS, S corporations).
The two words stop being interchangeable in one place. For Chapter 3 withholding the IRS reserves flow-through entity for a narrower list, a foreign partnership other than a withholding foreign partnership, and a foreign simple or foreign grantor trust other than a withholding foreign trust (IRS, Flow-through entities). A domestic partnership or S corporation is a pass-through entity in the ordinary sense without appearing on that list.
What Pass-Through Treatment Does Not Remove
Pass-through treatment is written against one chapter of the Code, not against the Code as a whole, so taxes imposed elsewhere survive it. For purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity even while it is disregarded for income tax (IRS, Single member limited liability companies).
State tax is a separate system, and one state-level charge runs the other way. Notice 2020-75 records that certain jurisdictions had enacted, or were contemplating the enactment of, tax laws imposing either a mandatory or elective entity-level income tax on partnerships and S corporations doing business there (IRS, Notice 2020-75). That pass-through entity tax sits at exactly the level federal pass-through treatment leaves empty, and its interaction with the state and local tax deduction is in SALT deduction.
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