It’s common for businesses to seek safe, effective, lawful ways to minimize their tax liability. A high tax bill can throttle a business, limiting growth and innovation. However, if your business operates as a pass-through entity, it may be easier to preserve funds, pay yourself in the early stages of your business, and grow to your full potential.
Stick around to see what businesses need to consider when choosing the right business type and how Mosey can work to keep businesses compliant.
Key Takeaways
- Pass-through entities avoid double taxation by flowing business income directly to owners, who report it on their individual tax returns rather than paying corporate income tax at the entity level.
- Common business types like sole proprietorships, partnerships, LLCs, and S corporations function as pass-through entities—each with different advantages and disadvantages.
- Multi-state pass-through entities need proper registration, annual franchise reports, registered agents, and state-specific business licenses in every jurisdiction where they operate.
What Is a Pass-Through Entity?
A flow-through entity, also called a pass-through entity, is a business that distributes its earnings to its owners, members, or shareholders directly rather than to the entity itself. Because the entity itself doesn’t have an income, the earnings are reported on an annual income tax return by people who receive a share of the profits.
All income is divided and reported, and appropriate taxes are paid. There is no legal requirement for every type of business structure to pay corporate taxes, as the requirement for corporations is specifically written into the rules for applicable structures. There are numerous business structures intended to be utilized as pass-through entities.
What Is Double Taxation?
Business earnings can be taxed multiple times from the moment they become business income until they eventually become someone’s paycheck. Money gets whittled down in incremental percentages until a substantial portion of the money is converted into taxes throughout its lifecycle.
Owners of C corporations face what is known as double taxation. They’ll pay a flat corporate tax rate of 21 percent in addition to taxes on the earnings they personally receive. By bypassing the corporation, earnings are only taxed once as individual income.
What Types of Pass-Through Entities Can Your Business Become?
Several common business types are generally treated as pass-through entities unless they specifically elect to be treated otherwise. Understanding the differences between business types helps you make the right choice.
There is no federal entity-level tax for these types of pass-through businesses:
- Sole proprietorship
- Limited partnership (LP)
- Limited liability partnership (LLP)
- General partnership
- Limited liability company (LLC)
- S corporation
C corporations are not pass-through entities. However, eligible corporations can elect to be taxed as an S corporation, which is a pass-through tax status. All C corporation profits are subject to the 21 percent corporate flat tax before profits can be distributed, and shareholders’ share of income will be taxed again. C corporations must also file a corporate income tax return separate from their owners’ personal returns.
The fact that LLCs can function as pass-through entities makes them popular choices for small business owners. Limited liability companies generally offer flexibility that attracts entrepreneurs.
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How Does a Business Become a Pass-Through Entity?
Most business structures are treated as pass-through entities by default. The only type of business entity that isn’t automatically regarded as a pass-through entity is a C corporation. Every type of LLC or partnership, as well as sole proprietorships, will be treated as a pass-through entity by default.
Single-member LLCs (also called owner LLCs or an LLC with one member) are regarded as sole proprietorships because a sole proprietor essentially runs them, and multi-member LLCs are treated as partnerships and subject to partnership taxes. Limited liability companies offer flexibility that makes them attractive to many business owners, whether you’re forming an LLC today or evaluating existing structures.
S corporations are slightly different. An S corp isn’t technically a business structure — it’s a tax classification. All businesses have the option of electing to be taxed as an S corporation if they meet the necessary criteria. Many eligible flow-through entities—such as LLCs—choose to be taxed as an S corporation for its potential tax benefits.
What Is an S Corporation and How Does LLC Work With This Election?
An S corporation is a tax status election that most corporations can make. An S corporation is a domestic small business corporation with no more than 100 shareholders or members, all of which must be U.S. citizens or permanent residents. Nonresident aliens, other businesses, and many types of entities are ineligible to act as shareholders.
Profits are divided and passed through every member of the corporation. You can generally claim eligible credits and deductions on your personal tax return (Form 1040) for your share of income. Up to 100 individual income tax returns will be filed, and each person will pay income tax or receive a refund if eligible based on tax filing requirements.
An eligible C corporation can elect to be taxed as an S corporation in order to become a pass-through entity. Some eligible pass-through entities—such as LLCs—can elect to be taxed as an S corporation to reduce self-employment tax exposure.
Corporations that elect to be taxed as S corporations can prove eligibility and file a separate tax election form with the IRS stating their preferred IRS tax classification. You’ll also need proper tax IDs before making this election.
Understanding the Section 199A Qualified Business Income Deduction
Pass-through entity owners may qualify for a significant deduction under Section 199A. This qualified business income (QBI) deduction allows eligible business owners to deduct up to 20% of their qualified business income from their taxable income.
The 199A deduction applies to many pass-through entities including sole proprietorships, partnerships, LLCs, and S corporations. However, limitations and phase-outs apply based on income levels and business type. High-income earners and certain service businesses face restrictions on this deduction, so understanding your eligibility is crucial for tax planning.
This deduction significantly reduces the effective tax rate for qualifying pass-through income, making this form of taxation work even more attractively for small business owners and entrepreneurs who meet the 199A requirements.
What Is the Difference Between a Disregarded Entity and a Pass-Through Entity?
A pass-through entity is a situation where a business is recognized but is primarily considered to be the individuals who run the business. A disregarded entity is a situation where the business is only one person. Single-member LLCs and sole proprietorships are always disregarded entities.
The IRS ignores that the income was generated through a business and attributes all business financials to the sole individual utilizing the business to make a profit. LLC owners in this situation report income and business expenses directly on Schedule C of Form 1040. Individuals can make estimated quarterly tax payments according to a schedule to stay ahead of their obligations. The quarterly estimated payments are usually based on similar income in previous years or on reasonable estimates for new businesses.
In the case of single-member LLCs, a disregarded entity can have employees. Those employees make their required tax contributions from their paychecks, and single-member LLC managers will likely still be required to pay employment taxes.
What Are the Pros and Cons of Pass-Through Entities?
Many businesses enjoy their status because of the potential pass-through entity tax savings. Eliminating the potential for double taxation can increase business profits. The potential downside of a flow-through entity occurs when it’s time to reinvest in the business, which can lead to the taxation of investments.
The Pros of Pass-Through Entities
The tax treatment is the most apparent benefit of electing to be taxed as a pass-through entity or an S corporation. The corporate tax is completely removed from the equation, meaning that profits are only taxed once. Members will still pay taxes but will do so at a personal income tax rate. They’ll also be able to take as many personal deductions as they’re eligible to take.
The Cons of Pass-Through Entities
The most significant downside of a pass-through entity is how income must be reported, regardless of how it’s utilized. A single-member LLC who decides not to collect a substantial paycheck from their business in favor of reinvesting most of the profit into business growth would still be taxpayers on the money that they didn’t personally keep.
This can put younger businesses at a disadvantage. You aren’t allowed to ignore reinvestment for tax purposes or write it off the way you would if you weren’t a pass-through entity. Some businesses elect not to be taxed as a pass-through entity until they’ve built themselves to a point where they’re comfortable with their upward trajectory for this very reason.
If you are a business owner concerned with these implications, there may be suitable solutions to this dilemma. You can consult with business formation experts or a local business tax professional about your plans and the options available to you before you make any major decisions regarding your tax classification. A business type comparison tool can also help you understand the advantages and disadvantages of each structure.
How Does Being a Flow-Through Entity Affect State Tax?
Your tax designation primarily applies for federal income tax purposes. Being a flow-through entity won’t exempt you from paying any taxes you may owe to your state. States make their own laws and set their own rates for corporate income tax and state income tax.
Depending on where your business is registered, you may have to pay a flat or tiered tax rate depending on your business income and revenue. Many states have implemented tax cuts for businesses, hoping that reducing the overall tax burden for entrepreneurs and startups will help local economies thrive. Some jurisdictions like Delaware corporations enjoy certain advantages, though pass-through entities still face obligations.
You’ll need to consult local laws for more information regarding state tax policy. Requirements can vary significantly based on locale.
Multi-State Compliance: Business Name Availability and Registration Requirements
Pass-through entities operating across state lines face requirements beyond just taxation. Each state where your LLC or S corporation conducts business requires separate registrations, licenses, and ongoing filings.
Before you can operate in a new state, you need to verify business name availability in that jurisdiction. Your business name must be distinguishable from existing entities on file with the Secretary of State. If your preferred name is unavailable, you may need to register under a slightly different name or file a DBA (doing business as) name.
LLCs and corporations must complete foreign qualification when expanding to new states. This process involves filing articles of incorporation or similar formation documents, appointing a registered agent, and paying filing fees. Each state has different requirements and processing times. Many Virginia businesses, for example, must navigate Virginia business license (BPOL) requirements that differ from neighboring states. Various incorporation packages, formation services, and small business services can help streamline this process.
Most states require pass-through entities to file annual franchise reports to maintain good standing. These filings typically include updated business information and require payment of annual franchise tax or renewal fees. Missing an annual franchise report deadline can result in penalties, late fees, and eventually administrative dissolution of your entity registration.
You’ll also need registered agents in every state where you’re qualified. Some jurisdictions require specific licensing requirements beyond just entity registration, including local business licenses (sometimes called BPOL licenses) at the city or county level.
How Mosey Can Help With Multi-State Pass-Through Entity Compliance
Pass-through entities face more than just entity tax obligations—especially when operating across state lines. Each state where your business operates requires separate entity registrations, annual franchise tax reports, registered agents, and compliance tracking. Miss a filing deadline in Nevada while managing California and New York obligations, and penalties pile up fast.
Tax compliance is a serious concern for businesses of all sizes. Your ability to meet your tax obligations with your state and local government is what determines your ability to operate and grow. But entity-level compliance—registration, annual reports, registered agents—matters just as much.
Mosey’s compliance automation solutions help you keep track of state and local tax compliance (as well as many other state business compliance issues) through one simple dashboard. From foreign qualification and registered agent services to automated annual report reminders and business name searches, Mosey handles entity-level compliance across all 50 states.
While your CPA handles tax strategy, Mosey ensures your pass-through entity stays registered, compliant, and operational in every state where you do business. Whether you’re managing revenue across multiple jurisdictions or just starting out, Mosey transforms entity management from a burden into a competitive advantage.
Schedule a demo with Mosey to learn how we can help your small business stay on the right track.
Frequently Asked Questions: The Pass-Through Entity
What is the meaning of pass-through entity?
A pass-through entity is a business structure where income “passes through” directly to owners and is taxed only on their personal tax returns. This avoids the double taxation that traditional C corporations face.
What is the difference between a pass-through entity and an LLC?
An LLC is a business structure type, while pass-through entity describes how a business is taxed. Most LLCs are pass-through entities by default unless they elect to be taxed as a C corporation.
What does pass-through mean in business?
Pass-through in business means profits and losses flow directly to owners’ individual tax returns without the business paying entity-level corporate income tax. Owners report their share of business income on Form 1040 and pay at their individual tax rate.
How does a pass-through entity work?
A pass-through entity works by allocating income, deductions, and credits to owners based on their ownership percentage, which they report on individual tax returns. The entity files an informational return but doesn’t pay federal income tax itself.
What is the benefit of a pass-through entity?
The primary benefit of a pass-through entity is avoiding double taxation—business profits are taxed only once at the owner level. Owners may also qualify for the Section 199A qualified business income deduction, reducing their effective tax rate further.
What are the disadvantages of pass-through taxation?
The main disadvantage of pass-through taxation is that owners pay tax on all allocated business income even if they don’t receive cash distributions. This creates tax liability on reinvested profits, which can strain cash flow for growing businesses focused on expansion.
