A pass-through payment is money that moves from its source to its intended recipient by way of an intermediary who holds the funds temporarily but has no legal ownership of them. The intermediary’s job is administrative: receive the money, follow the disbursement instructions, and deliver the correct amount to the final payee. You see this structure constantly in construction contracts, pharmacy benefits, legal settlements, and anywhere else the party writing the check doesn’t have a direct payment relationship with the person who actually earned the money.
The Three Parties and Why the Structure Exists
Every pass-through payment involves three roles. The originator provides the funds for a specific purpose. The intermediary receives the money and manages the logistics of distributing it. The ultimate payee is the person or business the money was always meant for. The intermediary is a conduit, not a beneficiary.
The setup exists because the originator usually owes money to many different parties and doesn’t want to cut dozens of separate checks. A property owner building a house doesn’t pay each plumber, electrician, and framer individually. One payment goes to the general contractor, who splits it up. A health plan doesn’t reimburse every pharmacy directly. It pays a pharmacy benefit manager, who handles the distribution. One outbound payment from the originator, multiple inbound payments to the people who did the work.
The intermediary’s obligation to pass the money along is what separates these transactions from ordinary business income. When a contractor receives payment that includes subcontractor shares, that portion was never the contractor’s revenue. It was earmarked before it arrived. Clear documentation of that earmarking is what keeps the intermediary out of trouble with both creditors and the IRS.
Where You’ll See a Pass-Through Payment
Construction
A property owner pays the general contractor for completed phases of work, and that payment typically includes amounts owed to subcontractors and material suppliers. The general contractor is contractually required to distribute those portions downstream, usually within a tight window. On federal construction projects, prime contractors must pay subcontractors within seven days of receiving payment from the government agency, and interest penalties accrue for every day beyond that deadline.1Office of the Law Revision Counsel. 31 USC 3905 – Payment Provisions Relating to Construction Contracts The same statute requires that identical payment and interest penalty clauses flow down to every tier of subcontractor.
Private projects don’t have a single federal rule governing payment timelines. State prompt payment statutes fill the gap, and most impose deadlines running from seven to thirty days after the general contractor receives funds from the owner. Late payment interest rates commonly fall between about 4% and 12% annually.
Pharmacy Benefits
Pharmacy benefit managers sit between health plan sponsors (employers, unions, or insurers) and retail pharmacies. Under a pass-through pricing model, the amount the plan sponsor pays for a prescription is the same amount the pharmacy receives. The PBM’s revenue comes from a flat administrative fee per transaction rather than from pocketing the spread between what it charges the plan and what it pays the pharmacy.
This is the opposite of spread pricing, where the PBM bills the plan sponsor more than it reimburses the pharmacy and keeps the difference. Pass-through arrangements exist specifically to eliminate that hidden margin. The plan sponsor can see exactly what the pharmacy was paid because the numbers match.
Legal Settlements
When a defendant or insurer settles a claim, the check is typically made payable to the plaintiff’s law firm rather than to the injured person directly. The firm deposits the settlement into an Interest on Lawyer Trust Account (IOLTA), a special bank account that keeps client funds completely separate from the firm’s operating money. Every state requires lawyers to maintain this separation, and the consequences for blending client funds with firm funds range from disciplinary action to disbarment and criminal prosecution.
Once the check clears, the firm calculates the net payout. Litigation costs come out first: filing fees, expert witness charges, deposition transcripts, and similar expenses. The attorney’s fee is subtracted next. The remaining balance goes to the client.
How the IRS Treats the Money
The central tax question for any intermediary is whether the IRS will treat the pass-through funds as the intermediary’s gross income. Federal law defines gross income as “all income from whatever source derived.”2Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined That phrasing sounds like it would sweep in everything a contractor or PBM touches, but the claim of right doctrine limits the reach. A taxpayer only includes an amount in gross income when they receive it under a claim of right and without restriction on how they can use it. An intermediary with a contractual obligation to pass funds along never has unrestricted control, so the funds aren’t the intermediary’s income.
Revenue Ruling 58-220 reinforces this principle. In that ruling, employee physicians who received patient payments and immediately endorsed them over to their hospital were treated as agents, and the income belonged to the hospital (the principal), not the doctors (the agents).3Internal Revenue Service. Agency – A Critical Factor in Exempt Organizations Accountable to the IRS The same logic applies to a general contractor passing subcontractor shares downstream or an attorney disbursing settlement funds from a trust account. If the intermediary is truly acting as an agent, the principal bears the tax liability.
The intermediary still has reporting obligations. When someone receives a payment on behalf of another person, the IRS treats them as a “nominee” and expects the appropriate 1099 to be filed to redirect the income to the true owner. This keeps the IRS from seeing a large deposit in the intermediary’s accounts and assuming it’s unreported business revenue. The agency’s automated matching system flags discrepancies between bank deposits and reported income quickly.
For services payments, the Form 1099-NEC filing threshold matters. Starting with payments made after December 31, 2025, the threshold rises from $600 to $2,000.4Internal Revenue Service. Form 1099-NEC and Independent Contractors So a general contractor who passes $1,500 to a subcontractor for services in 2026 no longer triggers a 1099-NEC filing, though the subcontractor still owes income tax on the money whether or not a form is issued.
Not the Same as a Pass-Through Entity
The phrase “pass-through” means something entirely different in business taxation, and the two concepts get confused all the time. A pass-through entity is a business structure (an S-corporation, partnership, or sole proprietorship) where the company itself pays no federal income tax. Profits and losses flow through to the owners’ personal returns.5Legal Information Institute. Pass-Through Taxation That’s a question of how a business is taxed.
A pass-through payment has nothing to do with business structure. It describes a specific transaction where money moves through an intermediary on its way to someone else. A C-corporation can handle pass-through payments. An S-corporation’s ordinary revenue isn’t a pass-through payment just because the entity is a pass-through for tax purposes. One phrase is about the taxpayer; the other is about the money.
What Goes Wrong When Pass-Through Funds Are Mishandled
Temporary custody of other people’s money creates serious exposure when things go wrong. The most common failure is commingling, which means mixing pass-through funds with the intermediary’s own operating cash. For attorneys, commingling trust account funds with firm money violates professional conduct rules in every state and can result in suspension or disbarment even if the client’s money is eventually returned in full. Intentional misappropriation is a criminal offense that has put lawyers in prison.
Construction contractors who divert subcontractor payments to cover other business expenses face breach-of-contract claims and, in many states, criminal charges for misapplication of construction trust funds. Several states treat construction project funds as statutory trusts, meaning the contractor is a trustee by operation of law. Diverting those funds is a breach of fiduciary duty with potential criminal penalties, not just a contract dispute.
On federal projects, prime contractors who miss the seven-day payment window required by the Prompt Payment Act owe interest at a rate published semiannually by the Treasury Department.6eCFR. 5 CFR Part 1315 – Prompt Payment The interest runs automatically from the day after payment was due until the day it is actually made. Subcontractors don’t have to demand it or file a claim; it accrues by statute.1Office of the Law Revision Counsel. 31 USC 3905 – Payment Provisions Relating to Construction Contracts
The tax consequences can be just as damaging. If the IRS determines that an intermediary exercised control over funds beyond what a true conduit relationship requires, those funds may be reclassified as the intermediary’s gross income. At that point the intermediary owes income tax, potential accuracy-related penalties, and interest on the unpaid balance stretching back to the original filing deadline.