What Is Pass-Through Taxation?
Pass-through taxation means the business itself pays no federal income tax. Profits “pass through” to the owners, who report them on their personal returns and pay tax at their individual rates. It is the default for LLCs, and it is the main reason an LLC is usually simpler at tax time than a C-Corporation. It also contains the detail that surprises nearly every first-time owner: you are taxed on profit, not on what you withdraw.
How it works, and how it differs from a C-Corp
A C-Corporation is taxed twice: the corporation pays corporate income tax on its profit, and shareholders pay tax again on dividends they receive. A pass-through entity is taxed once, at the owner level.
For a single-member LLC, that means the LLC is a disregarded entity and you report business income and expenses on Schedule C with your Form 1040. For a multi-member LLC, the LLC files an informational Form 1065 and issues each member a Schedule K-1 with their share, which they report on their own return.
Sole proprietorships, partnerships, S-Corporations, and most LLCs are all pass-through structures. The LLC is unusual only in that it can choose to leave the category by electing corporate taxation.
You are taxed on profit, not on withdrawals
This is the part that catches people. If your LLC earns $80,000 in profit and you leave $30,000 in the business account for next year’s expenses, you are still taxed on the full $80,000. The money you did not take home is still your taxable income.
The practical consequence is a cash-flow trap: owners who reinvest heavily can face a tax bill larger than the cash they actually withdrew. The defense is to set aside a percentage of every profit dollar as it is earned, in a separate account, and to make quarterly estimated tax payments rather than waiting for April.
Self-employment tax comes with the territory
Pass-through profit from an active business is generally subject to self-employment tax — 15.3% covering Social Security and Medicare — in addition to income tax. This is on top of your ordinary rate, and it is why a $100,000 profit does not feel like a $100,000 salary.
This is also the pressure that makes the S-Corp election attractive at higher profit levels: an S-Corp lets you split profit between a reasonable salary (subject to payroll taxes) and distributions (which are not subject to self-employment tax), at the cost of running payroll and filing a separate return.
The QBI deduction
Owners of pass-through businesses may be able to deduct up to 20% of qualified business income under Section 199A. It is a deduction against taxable income, not a credit, and it can meaningfully lower the effective rate on business profit.
It is also genuinely complicated: it phases out at higher income levels, applies differently to specified service trades and businesses, and interacts with wages and property held by the business. Provisions in this area have been subject to legislative change, so treat the specifics as something to confirm with a tax professional for your year and situation.
Key takeaways
- Pass-through taxation means the business pays no federal income tax — profits are taxed on the owners’ personal returns.
- It avoids the double taxation that applies to C-Corporation profits distributed as dividends.
- You are taxed on the LLC’s profit, not on the amount you withdraw — reinvested cash is still taxable.
- Active business profit is generally also subject to 15.3% self-employment tax.
- The Section 199A QBI deduction may allow up to a 20% deduction, with significant limitations.
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