Tax law: Everything advisers need to know about the pass-through provision

Updated January 16, 2024 

When entrepreneurs are deciding on the type of business structure applicable for their business, one of the most important things to consider is taxes. 

Tax treatments differ according to the structure of an entity, so choosing one that minimizes the impact of tax burden is essential. Financial advisors should inform clients about the law’s pass-through provision.  

In this article, we’ll discuss what pass-through entities are, their advantages and disadvantages, and the pass-through provisions that support such entities. 

What is the pass-through entity tax provision? 

Pass-through is a concept under taxation law where entities pass their income through to their owners’ tax returns, taxed at the owner’s individual rate.  

The entity’s incomes are taxed individually or based on the rates for individuals (individual income tax), instead of that of a corporation (corporate income tax). 

By contrast, corporations pay taxes twice: first, at the entity level, and second, when it distributes earnings to its shareholders.  

When an entity is structured as a pass-through, it will just shift its earnings and losses to the individuals running such entity (e.g., owners, shareholders, stockholders). 

In short, pass-through entities pay individual income taxes, not corporate income taxes. 

Pass-through businesses are allowed under the tax laws of different jurisdictions. That’s why they’re called pass-through provisions. 

Tax treatment of pass-through businesses 

Under the US tax code, pass-through businesses pay income taxes on their owners’ tax returns, based on individual income tax rates. 

A pass-through entity would also have to pay the following taxes: 

• self-employment taxes (SE taxes) 
• alternative minimum tax (AMT) 
• state and local taxes 

SE tax (consisting of Social Security and Medicare taxes) is paid by pass-through businesses. Individuals who need to pay SE taxes include owners of S corporations, sole proprietorships, and partnerships. Passive shareholders of S corporations do not need to pay SE tax. 

What are the advantages of pass-through provisions? 

Starting or struggling businesses may want to establish or switch as a pass-through entity, whenever allowed by the law’s pass-through provisions. Pass-through provisions of the law will lessen the impact of taxation on these small businesses without violating any tax laws. 

Here are other advantages of pass-through entities: 

Easier filing of taxes 

Filing returns and paying taxes are simpler for individuals than corporations. 

As such, pass-through businesses can do away with filing returns as required by tax laws specifically for corporations. 

For example, between an S corporation and a C corporation, the forms of returns as required by the Internal Revenue Service (IRS) are simpler for an S corporation.  

Prevent double taxation 

While double taxation is not illegal per se, there are several ways to prevent being taxed twice. One way is by using the law’s pass-through provision. 

Double taxation occurs when the same person or entity is taxed twice for the same income or revenue. This can happen to C corporations. Since C corporations are taxed separately from their owners under US tax law, they are common “victims” of double taxation. 

When C corporations generate profits, they must pay income taxes at the corporate level, with a tax treatment of a corporation. When dividends are distributed to its shareholders, they again have to pay taxes as they file their individual returns, now with the tax treatment as that of an individual. 

The same profits are taxed twice: first at the corporate level, then at the individual level. 

By structuring an entity as an S corporation or any other pass-through entity, double taxation is prevented since the “first” level of paying taxes is eliminated.  

Watch this video to know more pass-through provisions and how these are used by pass-through businesses: 

What are pass-through entities?  

Pass-through entities are businesses, organizations, or institutions that make use of the law’s pass-through provisions. 

Pass-through entities are also called “flow-through entities” and “fiscally-transparent entities”.  

Some examples of pass-through entities include:  

• sole proprietorships 
• partnerships 

• S corporations 
• limited liability companies or limited liability partnerships 

Many businesses in the US are structured as pass-through entities, because of the practical and tax advantages. 

Below is a discussion of each pass-through entity: 

Sole proprietorships 

Sole proprietorship is the most common type of business structure in the US, since it’s the simplest. 

Under tax laws, sole proprietorship is an unincorporated business owned by a single individual. Since there’s no distinction between the business and the owner, there’s no need for a separate income tax for the proprietorship.  

Sole proprietorships are pass-through entities because taxes are paid only by the owner (based on their individual return), and not by the business. 

Owners just need to report their profits and losses to the IRS and file their tax returns as an individual would. 

Partnerships 

Under American jurisdiction, partnerships are defined as the relations between two or more persons (called partners) joining to carry out a common trade or business.  

The main goal of partnerships is to divide profits (and losses) among these partners, who contribute money, property, labor, or industry. 

As allowed by the tax code’s pass-through provisions, the partnership itself does not pay income tax. Instead, it allocates a share of its net income to its partners. In turn, these partners report the partnership’s income and loss through their personal tax returns. 

While partnerships do not need to pay income taxes, they must still file an annual return for their income, deductions, gains, and losses. 

S Corporations 

S corporations are special types of corporations different from C corporations. Under US tax laws, S corporations are treated by the IRS as a partnership and not as a C corporation.  

Like the other pass-through businesses, S corporations do not need to pay federal corporate income taxes; these are passed to the corporation’s shareholders. These shareholders, in turn, will declare these taxable income, credits, deductions, and losses individually. 

This means that there are more possibilities for S corporations to save on gains because they have lower tax liabilities compared to C corporations. 

While this may be the case, an S corporation must still file their tax returns. It must do so at the end of the fiscal year. C corporations, on the other hand, must file their returns every quarter. 

Limited Liability Companies (LLCs) 

LLCs are another flow-through entity which is governed and authorized under state laws. Much like partnerships and Limited Liability Partnerships (LLPs), an LLC’s profits can be “passed through” as part of its owner’s personal income tax. 

Along with the advantage of using the law’s pass-through provision, LLCs and LLPs also have another advantage. Compared to being a general partner, limited partners are not personally liable for the debts of the company or the partnership. 

What are pass-through provisions under the law? 

Pass-through provisions fall under the tax code or the federal Internal Revenue Code (IRC). These pass-through provisions are implemented (and monitored when applied) by the IRS. 

There have been previous amendments to the IRC, which greatly affect the pass-through provisions of the law. One of these important amendments was introduced by the Tax Cuts and Jobs Act. 

Tax Cuts and Jobs Act 

The Tax Cuts and Jobs Act, which was signed into law on Dec. 22, 2017, created a new section in the US tax code: Section 199A. This pass-through provision created the qualified business income deduction (QBID) for households with income from pass-through businesses. 

Through the QBID, a tax break is provided to some pass-through businesses by allowing individuals to exclude up to 20% of their pass-through business income from federal income tax. 

Eligibility criteria for pass-through deductions 

According to this pass-through provision, non-corporate taxpayers are eligible for up to 20% deduction of their: 

• qualified business income (QBI) 
• qualified real estate investment trust (REIT) dividends 
• qualified publicly traded partnership (PTP) income 

Any trade or business may use these deductions, with certain exceptions as discussed below. 

These eligible trades or businesses under the tax code should meet these conditions: 

• business is regular and continuous 
• main intent is to earn profits 
• activities are done full time or part time 
• trade/business must be in the US  

This pass-through provision applies to two kinds of businesses: 

1. Specified service trades or businesses (SSTB): generally eligible under the pass-through provision, but would not be eligible if its income is above the phase-out limits 

2. Non-specified service trade or business (Non-SSTB): generally eligible under the pass-through provision, but only for the lesser amount of the following:  

• 20% of business income or  
• the greater of: 

• 50% of wages the business pays to employees, or 
• 25% of wages plus 2.5% of the cost of depreciable assets 

Exceptions to the deduction of the pass-through provision 

Not all entities or businesses may claim the full deduction under the amended pass-through provision. 

Generally, any trade or business is qualified under the pass-through provision, except for: 

• trade or business conducted by a C corporation 
• trade or business by employees who perform services 
• cooperatives, which are eligible for other deductions under the tax code 
• SSTBs which exceed the set threshold amounts 

For SSTBs, the threshold amounts as of 2023 are: 

Taxpayer	Threshold Amount	Phase-in/Phase-out Amount
Married individuals filing jointly	$364,200	$464,200
Married individuals filing separately	$182,100	$232,100
All other returns	$182,100	$232,100

Here are some of the following tax implications of taxpayers who exceed the threshold amount: 

• Taxpayers whose taxable income exceeds the threshold amount: the QBID phases in or phases out, subject to certain computations that will apply to determine the allowed deduction. 
• Taxpayers engaged in SSTBs whose taxable income exceeds the threshold amount: the QBID is eliminated. Stated earlier, they are not qualified from availing the QBID. 
• Taxpayers not engaged in SSTBs whose taxable income exceeds the threshold amount: other rules apply to determine the amount of QBID. 

The above thresholds are subject to yearly inflation. Also, the taxable income used in the pass-through provision is a taxpayer’s overall taxable income, not just the business income. 

How are taxes of pass-through provisions computed? 

Under the pass-through provision of the US tax code, pass-through businesses can determine their tax liability by:  

1. Calculating its net income (which is gross income less deductible expenses) 

2. Each owner or shareholder will include their portion of the business’ net income on their individual tax returns 

However, there would be some variations on what the basis of these taxes is: 

• For sole proprietorships: tax is based on the owner’s total net income 
• For S corporations and partnerships: tax is based on each shareholder’s percentage share of net profit 

There are also important considerations when applying tax breaks under the pass-through provision: 

• While the QBID reduces a taxpayer’s taxable income but not their adjusted gross income, they can still get the tax break whether they itemize on their tax returns or take the standard deduction. 
• The tax break is based on ownership interest. For example, an individual who owns 25% of a partnership can only get the exclusion of 25% of its net business income. 
• The calculation is done on an entity-by-entity basis. An individual with two different rental properties held in LLCs must calculate the exclusions separately — their income can’t be combined. 

What is an example of a pass-through in taxation? 

Here are some examples provided by Tim Steffen, director of advanced planning in the Private Wealth Management group at Robert W. Baird & Co., where the pass-through provision is applied: 

Example 1

The unmarried owner of a non-service pass-through has $100,000 in business income, and has total taxable income of $125,000. Because the individual’s income is below the phase-out range, they qualify for the full 20% exclusion, meaning $20,000 of business income is excluded from taxation.

Example 2

The same business owner now has total taxable income of $300,000 (which exceeds the phase-out income limit). The business pays $15,000 in wages but has no depreciable assets. The owner will exclude from tax the lesser of: $20,000 (20% of business income); or The greater of:  $7,500 (50% of wages), or  $3,750 (25% of wages [$3,750] + 2.5% of assets [$0]) The owner would exclude $7,500 of pass-through income from tax, much less than in Example 1.

Example 3

Same scenario as Example 2, but the owner also purchased a building associated with the business for $500,000. The owner will exclude the lesser of: $20,000 (20% of business income); or The greater of:  $7,500 (50% of wages), or  $16,250 (25% of wages [$3,750] + 2.5% of $500,000 [$12,500]) The owner’s exclusion would be $16,250, greater than in Example 2.

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