Pass-through taxation, explained: How it works and why it matters for small businesses

For small business owners and early-stage founders, there are a million different business components that require your time and attention. But as you start, one thing you should absolutely be aware of is your tax situation.

If you’re just getting off the ground with your business (or you’re thinking about starting one) understanding how taxes will affect your bottom line is critical. The way your business is structured could determine how much you pay, how you file, and even how attractive your company is to future investors.

With this in mind, it’s important to understand pass-through taxation. In this article, we’ll break down how this structure works, explore its benefits, and help you decide if it’s the right approach for you and your business.

So let’s dive straight in.

What is pass-through taxation?

Pass-through taxation is a tax structure where business income is “passed through” to the business owner’s personal tax return, instead of being taxed at the business level.

In other words, the business doesn’t pay income tax — the owner does.

For instance, say you’re a freelance web developer who earned $60,000 in profit this year. Instead of filing a separate tax return for your business and paying a corporate tax rate, you’ll simply report that $60,000 as income on your personal return.

This structure applies to a range of small business types, including:

• Sole proprietorships (you and your business are legally the same)

• Partnerships (shared ownership with split income)

• S-corporations (S-corps) (requires special IRS election to be treated as a pass-through entity)

• Limited Liability Companies (LLCs) (unless elected a a C-corp)

These business types are often referred to as pass-through entities for this reason.

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In a C-corporation, your company pays taxes on its income and then shareholders pay again on dividends. This is known as double taxation — and it’s one of the biggest things pass-through taxation helps avoid.

How does pass-through taxation work?

Pass-through taxation is a relatively straightforward concept, and works in the following way:

1. Your business earns profit.

2. That profit passes directly to you (and other owners, if applicable).

3. You (and they) report it on your personal tax return.

4. You pay income tax on it at your individual rate.

To illustrate, here are some examples:

Example 1: A freelance designer with an LLC

Let’s say that you operate as a single-member LLC (pass-through by default), and your business income for the year is $90,000.

First, you would need to work out your profit. If your business expenses were $20,000 for the year, your profit would be $70,000.

This $70,000 would be reported on your personal tax return and taxed at your individual tax rate. You would also pay self-employment tax (Social Security and Medicare) — but there would be no corporate tax.

Example 2: A consulting partnership

Let’s say you operate with a close associate in a partnership. Your company’s income for the year is $200,000 and business expenses are $50,000, giving you a $150,000 profit.

As you have shared ownership of the business, you and your partner each claim $75,000 of income on your personal returns. Again, there’s no business-level income tax.

Both of these examples show how simple and direct pass-through taxation can be — but that doesn’t mean it’s right for everyone.

Pros and cons of pass-through taxation

Before deciding on a tax structure, it’s important to understand the advantages and disadvantages of pass-through taxation.

Benefits of pass-through taxation

Many small business owners stick with this for the following reasons:

1. No double taxation

Unlike with C-corporations, your business income is taxed once — when you report it on your personal tax return. That’s a major win for profitability.

2. Simplicity

Filing taxes as a sole proprietor or LLC is usually far simpler than filing as a corporation. There’s no separate business tax return (unless you’re a partnership or S-corp with multiple members).

3. Potential tax savings

Depending on your income, you might qualify for the 20% Qualified Business Income (QBI) deduction under the Tax Cuts and Jobs Act. This deduction can reduce your taxable business income significantly.

For example, if you earn $100,000 in qualified business income, you may be eligible to deduct $20,000 — lowering your taxable income to $80,000.

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4. Flexibility in profit use

Want to reinvest your profits into the business instead of taking a salary? With pass-through entities, you can do that without triggering extra payroll taxes.

Limitations of pass-through taxation

It’s not all sunshine and tax breaks. Here are a few trade-offs to consider:

1. Self-employment tax

If you're a sole proprietor, partner, or LLC member, you’re responsible for the full 15.3% self-employment tax (Social Security and Medicare).

2. Income limits for deductions

High earners may phase out of the QBI deduction if they’re in certain service industries (like law, accounting, or consulting).

3. State tax differences

Some states don’t recognize federal pass-through treatment — or impose additional business taxes. As a result, it’s crucial to always check local regulations.

4. Less incentive for investors

Pass-through entities don’t offer the same equity structures as corporations, which can make it harder to raise capital from VCs or institutional investors (if you’re looking to do so).

To pass-through, or not to pass-through?

If you’re just launching a business, ask yourself the following questions:

• Do you want your tax obligations to be simple and straightforward?

• Are you happy to pay self-employment tax?

• Is raising VC funding not a top priority?

• Do you want to avoid double taxation?

If you answered “yes” to most of these, a pass-through structure — like a sole proprietorship, partnership, or LLC — might be the way to go. If you’re unsure, it’s highly advisable to speak with a tax professional.

How can Remote help?

For founders, freelancers, and early-stage business owners, pass-through taxation offers flexibility, simplicity, and financial transparency. It’s a smart structure for many, especially when you’re building something lean, scrappy, and powerful from the ground up.

If you provide services to businesses, Remote’s Freelancer Hub can also help. It enables you to easily track all your invoices and manage all of your documents in one place, making it quick and painless to calculate your income.

To learn more about how Freelancer Hub can simplify your business and tax management, speak to one of our friendly experts today.