Michael Torres
Most small business owners I’ve met think pass-through taxation is some kind of loophole. It’s not. It’s just how the default tax system works for the majority of American businesses, and misunderstanding it has cost people real money.
I’ll be honest: when I first started advising small business clients back in the mid-2000s, I assumed most of them had at least a rough handle on why their business income showed up on their personal return. They didn’t. And I kept making the mistake of thinking a five-second explanation would be enough. It wasn’t then, and it probably isn’t now. So let me actually walk through this properly.
Pass-through taxation means the business itself doesn’t pay federal income tax. The profits (and sometimes the losses) “pass through” to the owners’ personal tax returns, where they get taxed at whatever the individual’s rate happens to be. That’s essentially the whole concept. But the implications of that simple mechanic are what trip people up.
- Pass-through entities don't pay corporate-level income tax; profits tax on owner returns instead.
- Sole props, partnerships, LLCs, and S-corps all qualify; C-corps do not.
- The 20% QBI deduction (Section 199A) can significantly reduce pass-through income tax, with income limits applying.
- Self-employment tax (15.3% on the first $168,600 in 2026) hits pass-through owners hard and is separate from income tax.
- Estimated quarterly payments are not optional, underpay and the IRS charges interest from the date each payment was due.
Which Business Structures Actually Pass Through
Not all entities work the same way here, and the differences matter more than most people realize.
Sole proprietorships are the simplest case. You file a Schedule C with your Form 1040, your net profit shows up as income, and that’s that. Partnerships file a Form 1065, then issue each partner a Schedule K-1 showing their share of profit, loss, credits, and deductions. LLCs are a chameleon: by default a single-member LLC is taxed like a sole prop, a multi-member LLC is taxed like a partnership, and either can elect S-corp status with the IRS. S-corporations file Form 1120-S and also issue K-1s.
C-corporations are the exception. They pay corporate income tax at the entity level (currently a flat 21% federal rate), and then shareholders pay tax again on dividends. That’s the famous “double taxation” you hear about. Most small business owners want nothing to do with it, and for good reason.
Here’s a quick comparison of how pass-through structures differ in practice:
| Entity Type | Tax Form Filed | How Income Reaches Owner | Self-Employment Tax? |
|---|---|---|---|
| Sole Proprietorship | Schedule C (Form 1040) | Directly on personal return | Yes, full SE tax |
| Single-Member LLC | Schedule C (Form 1040) | Directly on personal return | Yes, full SE tax |
| Partnership | Form 1065 + K-1 | K-1 to each partner’s 1040 | Yes, for general partners |
| Multi-Member LLC | Form 1065 + K-1 | K-1 to each member’s 1040 | Varies by structure |
| S-Corporation | Form 1120-S + K-1 | K-1 to each shareholder | Only on W-2 wages, not distributions |
That last row is where a lot of the “S-corp tax savings” conversation comes from. I’ll get to that.
The Part Nobody Explains Well: Self-Employment Tax
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This is where I see clients get blindsided. They hear “pass-through means you avoid double taxation” and assume their tax burden is light. It’s not always light. In fact, for a profitable sole prop or single-member LLC, the self-employment tax alone can feel brutal.
As of 2026, self-employment tax is 15.3% on the first $168,600 of net self-employment income (12.4% Social Security plus 2.9% Medicare), and then 2.9% on anything above that threshold. You can deduct half of SE tax on your personal return, which softens the blow a bit. But when you’re pulling $120,000 in net profit from a sole prop, you’re looking at roughly $16,955 in SE tax before income tax even enters the picture. I’ve had clients genuinely shocked by their first-year tax bill because nobody told them this was coming.
S-corp election can reduce this exposure, and that’s the legitimate reason some small business owners elect it. If you pay yourself a “reasonable salary” through payroll, you pay SE tax (technically payroll tax) only on that salary. Distributions above the salary don’t get hit. A client of mine in residential HVAC work, after a CPA review, shifted from a single-member LLC to S-corp status when her profits consistently cleared $95,000 annually. The payroll setup cost her around $1,200 a year in additional accounting fees, but she saved more than $4,000 in self-employment taxes. The math worked. But it doesn’t always work at lower profit levels, and I’d strongly recommend running it past a CPA before making that call.
Section 199A: The QBI Deduction
What surprised me when the Tax Cuts and Jobs Act passed was how underutilized the Section 199A deduction turned out to be. Even in 2026, I talk to business owners who’ve never heard of it.
Here’s the short version: if you have pass-through income, you may be able to deduct up to 20% of your “qualified business income” from your taxable income. So if your business generates $80,000 in QBI and you qualify fully, you’re only taxed on $64,000 of it. For someone in the 22% bracket, that’s a meaningful number.
The catch is that it gets complicated fast. There are income thresholds (in 2026, phase-outs begin at $191,950 for single filers and $383,900 for married filing jointly). Certain service businesses, what the IRS calls “specified service trades or businesses” (SSTBs), like consulting, law, financial services, and health get squeezed out at higher income levels. W-2 wage limitations apply. It’s genuinely one of the more convoluted pieces of current tax code. The IRS small business tax center has the official guidance, but I’d be lying if I said reading it cold was easy. This is a “talk to your CPA” situation, not a DIY one.
Estimated Quarterly Taxes Are Not a Suggestion
I want to be direct about this because I’ve seen it bite too many people.
When you receive pass-through income, no employer is withholding taxes for you. The IRS expects you to make estimated tax payments four times a year: generally April 15, June 16, September 15, and January 15. If you underpay, you don’t just owe the balance at filing, you also owe underpayment interest calculated from each individual due date. It’s not a penalty per se, more like interest that accrues quietly. But it adds up.
The “safe harbor” rule is your friend here. If you pay at least 100% of last year’s total tax liability (or 110% if your prior-year AGI exceeded $150,000), you won’t owe underpayment charges regardless of what you actually owe in April. I’ve recommended this approach to clients who have unpredictable income: just match last year’s number across four payments and stop worrying about projecting.
SCORE’s mentorship resources actually have solid worksheet templates for estimating quarterly payments if you’re starting from scratch and want a framework before talking to an accountant.
The chart above is illustrative, based on a single filer at $100K net profit with no deductions other than the standard and the SE deduction, but the relative pattern holds across most scenarios I’ve run. S-corp with QBI wins at that income level. Sole prop beats C-corp. These aren’t guarantees; individual circumstances shift the numbers considerably.
Losses Pass Through Too
This gets less attention than it deserves. If your pass-through business posts a loss, that loss can offset your other income, subject to at-risk and passive activity rules. A client who launched a boutique fitness studio in early 2024 ran at a $38,000 loss in year one. That loss reduced her W-2 income from a part-time hospital administration job she kept during launch, which meaningfully cut her tax bill for the year. It’s not a fun situation to be in, but it does cushion the financial blow of a rough first year.
The rules around how much of a loss you can actually use are genuinely complex. Passive activity loss limitations (from the Tax Reform Act of 1986, still alive and frustrating) can prevent you from using losses if you’re not materially participating in the business. I don’t have a simple answer here because it genuinely depends on your situation. For deeper reading, Tax Savvy for Small Business by Frederick Daily (available on Amazon, and yes, this site may earn a commission on that link) is one of the most practical plain-English guides I’ve found on these rules.
Sources
- IRS Publication 541, Partnerships: Official IRS guidance on partnership taxation and K-1 reporting.
- IRS Section 199A FAQs: IRS guidance on the qualified business income deduction and SSTB rules.
- IRS Self-Employment Tax Overview: Current SE tax rates and calculation rules.
- Tax Cuts and Jobs Act of 2017 (P.L. 115-97): Source legislation for the 20% QBI deduction and corporate rate changes.
- SCORE Small Business Resources: Free mentorship and financial planning tools for small business owners.
Photo: Leeloo The First via Pexels
This article is for general informational purposes only and does not constitute financial, tax, or legal advice. Business finance and tax rules vary by entity type, state, and individual circumstances. Consult a qualified CPA, enrolled agent, or business attorney for advice specific to your situation.
Recommended Resources
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- Mastering QuickBooks 2025 (~$32), The most comprehensive QuickBooks 2025 guide, covers bookkeeping, payroll, invoicing, tax prep, and cash flow.
- Accounting for Small Business Owners (~$14), Beginner-friendly accounting guide covering basic bookkeeping, financial statements, and managing business taxes.
