What Is a Flow-Through Entity and How Is It Taxed?

A flow-through entity is a business that pays no federal income tax at the company level; instead, its profits, losses, deductions, and credits pass directly to the owners, who report them on personal returns and pay tax at individual rates ranging from 10 percent to 37 percent in 2026.¹ That single layer of taxation is the core advantage over a traditional C corporation, where profits get taxed once at the corporate level and again when distributed to shareholders as dividends. Sole proprietorships, partnerships, S corporations, and most limited liability companies all fall into this category.

How Pass-Through Taxation Works

The mechanism is straightforward. The business calculates its income and expenses for the year, then allocates those numbers to each owner based on ownership share. Owners fold that income into their personal Form 1040, where it gets taxed alongside wages, investment gains, and everything else. The business itself files an informational return telling the IRS how much went to whom, but no check accompanies that filing.

The structure creates real advantages. If the business posts a loss, that loss flows through to the owner’s personal return and can offset other income like a spouse’s salary or investment earnings, lowering the household’s total tax bill.² Tax credits earned by the business, such as clean energy or research credits, also pass through to owners rather than sitting trapped inside the entity.³

The flip side: owners owe tax on their share of business profits whether or not the business actually distributes cash to them. A partnership that earns $200,000 and reinvests every dollar still creates a $200,000 tax bill split among the partners.⁴

The Four Types of Flow-Through Entities

Sole Proprietorships

A sole proprietorship is the simplest version because it doesn’t really exist as a separate entity. Run a business by yourself without forming an LLC or corporation and you’re a sole proprietor by default. The IRS treats you and the business as the same taxpayer, so there’s no separate business return.

You report revenue and expenses on Schedule C, which attaches to your Form 1040. List gross receipts, subtract costs like supplies, insurance, rent, and vehicle expenses, and arrive at a net profit or net loss on line 31.⁵ That bottom-line number feeds directly into your total income for the year.

Partnerships

When two or more people go into business together without incorporating, the default federal classification is a partnership. The partnership owes no income tax itself. It files Form 1065, an informational return that reports total income, deductions, and credits, then allocates each partner’s share on a separate Schedule K-1.⁶

The statute is blunt: a partnership “shall not be subject to the income tax,” and partners “shall be liable for income tax only in their separate or individual capacities.”⁷ Each partner picks up their distributive share of every item, including ordinary income, capital gains, charitable contributions, and foreign tax credits, and reports those items on a personal return. The partnership agreement controls how profits and losses split, but the IRS taxes each partner on the allocated share regardless of how much cash actually changes hands.

S Corporations

An S corporation starts as a regular corporation that then files Form 2553 asking the IRS to tax it as a pass-through. Once approved, the corporation avoids entity-level income tax, and its income, losses, deductions, and credits pass through to shareholders on a pro-rata basis.⁸ The company files Form 1120-S, which functions like Form 1065 for S corporation shareholders.

Shareholders who also work in the business face a rule that catches many owners off guard. Before taking distributions, the corporation must pay any shareholder-employee a salary that reflects the market rate for the work performed.⁹ That salary carries payroll taxes (Social Security and Medicare) like any other employee’s wages. Distributions above the reasonable salary generally are not subject to those payroll taxes, which is why S corporations are popular for reducing self-employment tax. The IRS and courts have consistently held that artificially low salaries designed to minimize payroll taxes will be reclassified as wages.

Limited Liability Companies

The LLC has no dedicated federal tax classification. The IRS slots LLCs into existing categories using default rules based on the number of owners. A single-member LLC is treated as a “disregarded entity”: the IRS ignores it for income tax purposes and the owner reports everything on Schedule C, exactly like a sole proprietor.¹⁰ A multi-member LLC defaults to partnership treatment, filing Form 1065 and issuing K-1s to each member.

LLCs aren’t stuck with the defaults. An LLC that wants to be taxed as a C corporation files Form 8832, and the election generally cannot take effect more than 75 days before the filing date or more than 12 months after it.¹¹ An LLC seeking S corporation treatment skips Form 8832 and files Form 2553 instead, which simultaneously elects both corporate classification and S status.

Self-Employment Tax on Pass-Through Income

Income tax is only part of the bill. Sole proprietors, partners, and most LLC members also owe self-employment tax, which funds Social Security and Medicare. The combined rate is 15.3 percent: 12.4 percent for Social Security and 2.9 percent for Medicare.¹² That’s effectively double what a W-2 employee pays, because employees and employers each cover half. When you’re self-employed, you cover both.

The Social Security portion applies only to the first $184,500 of net self-employment earnings in 2026.¹² The Medicare portion has no cap and applies to every dollar. Earnings above $200,000 for single filers ($250,000 for married couples filing jointly) also trigger an additional 0.9 percent Medicare surtax.¹³

There is some relief built in. You calculate the tax on Schedule SE and then deduct half of it on Schedule 1 of your Form 1040, reducing your adjusted gross income.¹⁴ S corporation shareholders avoid self-employment tax on distributions above their reasonable compensation, which is why many owners evaluate whether the S election would produce net savings after payroll processing costs.

The 20 Percent Qualified Business Income Deduction

Flow-through owners can deduct up to 20 percent of their qualified business income under Section 199A, effectively reducing the tax rate on pass-through profits.¹⁵ The deduction was originally scheduled to expire after 2025 but was made permanent by the One Big Beautiful Bill Act signed on July 4, 2025.¹

The deduction covers net income from sole proprietorships, partnerships, S corporations, and qualifying trusts or estates. It does not apply to wages you pay yourself from an S corporation, guaranteed payments from a partnership, or income earned through a C corporation.¹⁵ For owners of specified service businesses (law firms, medical practices, consulting, financial services), the deduction phases out as taxable income rises above certain thresholds, which the IRS adjusts annually for inflation. Below those thresholds, the full 20 percent applies regardless of business type.

Quarterly Estimated Tax Payments

Because no employer is withholding taxes from pass-through income, owners are responsible for sending the IRS money throughout the year through estimated tax payments. Miss them and you’ll owe an underpayment penalty on top of the tax, even if you settle the full balance by April.

For the 2026 tax year, the four payment deadlines are:

First quarter: April 15, 2026
Second quarter: June 15, 2026
Third quarter: September 15, 2026
Fourth quarter: January 15, 2027

Payments go in on Form 1040-ES or through the IRS online payment system.¹⁶

You avoid the underpayment penalty if total payments and withholding cover at least 90 percent of the current year’s tax liability or 100 percent of the prior year’s, whichever is smaller. If your adjusted gross income exceeded $150,000 in the prior year ($75,000 if married filing separately), that 100 percent threshold rises to 110 percent.¹⁷ Most accountants recommend the prior-year safe harbor because it’s a known number.

Limits on Using Losses

The ability to use business losses against other income isn’t unlimited. Federal law imposes several caps that can defer or block pass-through losses from reducing your taxable income in the current year.

The excess business loss limitation prevents noncorporate taxpayers from deducting business losses beyond a threshold amount (adjusted annually for inflation) plus their business income for the year. Losses above that ceiling become a net operating loss carryforward rather than an immediate deduction.¹⁸ Separately, the at-risk rules limit deductions to the amount you’ve actually invested or personally guaranteed, and the passive activity rules restrict losses from businesses you don’t materially participate in. These rules layer on top of each other, so a loss that clears one hurdle may still be blocked by another. Disallowed losses generally carry forward.

Filing Forms and Deadlines

Each type of flow-through entity has its own informational return, and the deadlines are earlier than most owners expect.

Sole proprietorships: no separate business return. Report on Schedule C with your Form 1040.
Partnerships and multi-member LLCs: file Form 1065, which reports total income, expenses, and each partner’s allocated share.¹⁹
S corporations: file Form 1120-S.

Both Form 1065 and Form 1120-S are informational only, with no tax payment. The business also issues a Schedule K-1 to each owner documenting that person’s share of income, deductions, and credits, which the owner then transfers to Form 1040.⁶

For calendar-year businesses, both returns are due by the 15th day of the third month after the tax year ends. For 2026, that falls on March 16 because March 15 is a Sunday.¹⁶ Schedule K-1s must be furnished to owners by the same date. Filing Form 7004 grants an automatic six-month extension, pushing the return deadline to September 15, 2026, but the extension does not remove penalty risk for late K-1s.

Late-filing penalties add up quickly because they’re calculated per owner per month. A partnership that files late owes a penalty for each month (or partial month) the return is overdue, multiplied by the number of partners, for up to 12 months.²⁰ The per-partner monthly amount is adjusted annually for inflation and was $220 for returns due in 2025. S corporations face an identical structure per shareholder. These penalties apply even when no tax is owed, because the returns are informational. Reasonable cause can support an abatement request, but not knowing the deadline rarely qualifies.

1
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
2
Internal Revenue Service. Publication 334 (2025), Tax Guide for Small Business
3
Internal Revenue Service. Credits and Deductions Under the Inflation Reduction Act of 2022
4
Internal Revenue Service. Publication 541 (12/2025), Partnerships
5
Internal Revenue Service. 2025 Instructions for Schedule C (Form 1040)
6
Internal Revenue Service. About Form 1065, U.S. Return of Partnership Income
7
GovInfo. 26 U.S.C. 701 – Partners, Not Partnership, Subject to Tax
8
Office of the Law Revision Counsel. 26 U.S. Code 1366 – Pass-Thru of Items to Shareholders
9
Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers
10
Internal Revenue Service. Single Member Limited Liability Companies
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Internal Revenue Service. Form 8832 Entity Classification Election
12
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14
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15
Internal Revenue Service. Qualified Business Income Deduction
16
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17
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18
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19
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20
Office of the Law Revision Counsel. 26 U.S.C. 6698 – Failure to File Partnership Return