Pass-through income tax is the individual income tax you pay on profits from a business that doesn’t pay tax at the entity level. Instead of the business writing a check to the IRS, its profits flow through to the owners and get reported on their personal Form 1040, where they’re taxed at ordinary income rates ranging from 10% to 37% for 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Sole proprietorships, partnerships, most LLCs, and S-corporations all work this way, and most owners can deduct up to 20% of that income before the tax is calculated.
How the Single Layer of Tax Works
A traditional C-corporation pays tax on its profits, and shareholders pay tax again when those profits come out as dividends. Pass-through structures skip the first layer. The business itself owes no federal income tax, and every dollar of profit or loss is assigned to the owners for the year it was earned.
That last part surprises people. Even if the business keeps the cash in its accounts to fund payroll or growth, you still owe tax on your share. Distributions and taxable income are separate concepts. Your share of business income lands on your personal return and stacks on top of wages, interest, dividends, and anything else you earned. The whole pile is then taxed under the standard federal brackets, which for 2026 start at 10% on the first $12,400 of taxable income for a single filer and reach 37% above $640,600.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
Which Businesses Are Pass-Throughs
Four common structures pass their income through to owners, and the small differences between them shape how you report and how much self-employment tax you owe.
A sole proprietorship is one person doing business without forming a separate entity. The IRS treats the owner and the business as the same taxpayer.2Internal Revenue Service. Sole Proprietorships Freelancers and independent contractors who never registered anything are usually sole proprietors by default.
A partnership is two or more people running a business together. The partnership files an information return but doesn’t pay tax itself; each partner’s share of income, losses, and credits is determined by the partnership agreement and reported on their own return.3Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share Fixed amounts paid to a partner regardless of profitability are “guaranteed payments,” which are ordinary income to the partner and deductible by the partnership.4Internal Revenue Service. Publication 541, Partnerships
A limited liability company protects owners from personal liability for business debts while keeping pass-through status. The IRS has no dedicated tax category for LLCs. A single-member LLC is a “disregarded entity” and files like a sole proprietorship; a multi-member LLC defaults to partnership treatment.5Internal Revenue Service. Single Member Limited Liability Companies
An S-corporation is a corporation that has elected pass-through status. It must be domestic, have no more than 100 shareholders, and have only one class of stock.6Internal Revenue Service. S Corporations Any shareholder who works in the business has to draw a reasonable salary before taking distributions. The IRS and the courts have consistently pushed back on attempts to disguise wages as distributions to avoid employment taxes.7Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers Paying yourself $30,000 when comparable professionals earn $90,000 is a good way to invite an audit adjustment.
Self-Employment Tax
Pass-through income has no employer withholding payroll taxes for you, so most owners owe self-employment tax on their net business earnings. The rate is 15.3%: 12.4% for Social Security and 2.9% for Medicare.8Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes) For 2026, the Social Security portion applies only to the first $184,500 of net self-employment income; the Medicare portion has no cap.9Social Security Administration. 2026 Cost-of-Living Adjustment (COLA) Fact Sheet
You calculate it on Schedule SE and get to deduct half of it when figuring your adjusted gross income. That deduction doesn’t reduce the self-employment tax itself, but it lowers the income subject to regular income tax.10Internal Revenue Service. Topic No. 554, Self-Employment Tax
S-corporation shareholders who work in the business handle this differently. They pay standard payroll taxes on their salary, but their share of the remaining profits passes through free of self-employment tax. That gap is why many small-business owners elect S-corp status once earnings justify the extra bookkeeping. The catch, again, is that the salary has to reflect the real value of the work.
How to Report Pass-Through Income
Every owner ends up on Form 1040.11Internal Revenue Service. About Form 1040, U.S. Individual Income Tax Return Where the numbers show up along the way depends on the entity:
- Sole proprietors report profit or loss on Schedule C, attached to the 1040.2Internal Revenue Service. Sole Proprietorships
- Partnerships file Form 1065 and issue each partner a Schedule K-1.12Internal Revenue Service. Entities 4
- S-corporations file Form 1120-S and issue each shareholder a Schedule K-1.12Internal Revenue Service. Entities 4
Partners and S-corp shareholders carry their K-1 figures onto Schedule E of the 1040. Neither Form 1065 nor Form 1120-S produces a tax payment from the business; they exist to give the IRS a record of what each owner should be reporting.
Partnership and S-corp returns are due March 15 for calendar-year businesses, and K-1s have to reach owners by that same date.13Internal Revenue Service. Publication 509 (2026), Tax Calendars Individual returns are due April 15. Late K-1s are one of the most common reasons owners file for an extension on their personal return.
Quarterly Estimated Payments
Because no employer is withholding tax from pass-through income, you generally have to make quarterly estimated payments if you’ll owe $1,000 or more when you file. For 2026, the due dates are April 15, June 15, September 15, and January 15, 2027.14Taxpayer Advocate Service. Making Estimated Payments
Underpaying triggers a penalty, but there’s a safe harbor. You’re protected if your total payments cover at least 90% of your current-year tax or 100% of what you owed the prior year, whichever is smaller.15Internal Revenue Service. Topic No. 306, Penalty for Underpayment of Estimated Tax Predicting current-year pass-through income is hard, so most owners rely on the prior-year figure. Individual taxpayers now pay through IRS Direct Pay or their IRS Online Account; the older EFTPS system is no longer taking new individual enrollments, though existing users can keep using it.16Internal Revenue Service. EFTPS: The Electronic Federal Tax Payment System
The 20% Qualified Business Income Deduction
Section 199A lets pass-through owners deduct up to 20% of their qualified business income from taxable income.17Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income It was set to expire after 2025, but the One Big Beautiful Bill Act signed in 2025 made it permanent. Someone in the 37% bracket effectively pays about 29.6% on qualifying business income.
The full 20% is available to any qualifying business below certain income thresholds. For 2026, the phase-out starts around $203,000 for single filers and $406,000 for joint filers.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Below those numbers, you get the deduction no matter what the business does.
Above them, it gets complicated. Owners in law, medicine, accounting, consulting, and financial services face restrictions that can reduce or eliminate the deduction. Other businesses above the threshold have to satisfy tests based on W-2 wages paid or the value of certain business property. Most owners in that range work with a tax professional.
The new law also added a floor for small but active businesses. If you materially participate in a business that generates at least $1,000 in qualified business income, you’re guaranteed at least a $400 deduction even if the standard 20% math would give you less. Both figures are indexed for inflation after 2026.17Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income
When the Business Loses Money
Pass-through losses can offset your other income, like wages or investment gains, but they have to clear a series of limitations first. The IRS applies them in order, and each can suspend losses that would otherwise reduce your tax.
The first is basis. You can only deduct losses up to your tax basis in the business. For an S-corp shareholder, basis is your stock cost plus any loans you personally made to the company.18Internal Revenue Service. S Corporation Stock and Debt Basis Losses beyond your basis aren’t lost; they carry forward until your basis goes back up, usually through more contributions or accumulated profits.
The second is the at-risk rule, which caps deductions at the amount you actually stand to lose financially. This blocks inflated deductions from nonrecourse loans or arrangements where someone else bears the real economic risk.19Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules
Third are the passive activity rules, where most people get tripped up. If you don’t materially participate in the business, losses from it generally only offset other passive income. Material participation is measured mostly by time. The clearest test is 500 hours during the year, though there are several alternatives, including working at least 100 hours when no one else worked more.20Internal Revenue Service. 2025 Instructions for Form 8582 – Passive Activity Loss Limitations Limited partners face stricter rules and generally have to meet the 500-hour test or show participation in five of the prior ten years.
Finally, Section 461(l) caps how much net business loss an individual can deduct against non-business income like wages or investment returns in a single year. The threshold is indexed for inflation. Anything above it carries forward as part of your net operating loss. This cap was made permanent by the One Big Beautiful Bill Act for tax years beginning in 2026 and later.
State Tax Sits on Top
Federal rules aren’t the whole picture. Pass-through income is also generally subject to state income tax, and most states with an income tax mirror the federal pass-through model, meaning your share is taxed on your personal state return. More than 30 states now offer an optional entity-level tax that lets the business itself pay state income tax, which creates a federal deduction at the entity level and works around the federal cap on state and local tax deductions. Whether that election helps you depends on your state’s rules and your income.
States also charge annual fees to keep an LLC, partnership, or corporation in good standing, ranging from nothing in a handful of states to over $800 in the most expensive ones. These are owed whether the business made money or not.