A pass-through entity is a business structure where income, deductions, credits, and losses flow through to the owners' personal tax returns rather than being taxed at the business level. Common structures include LLCs, S corporations, partnerships, and sole proprietorships.
For many small business owners in Illinois and across the country, the right pass-through entity can reduce overall tax liability and simplify reporting. The best choice, however, depends on factors such as income, ownership structure, and long-term business goals. Our business tax planning team at Lewis.cpa helps business owners evaluate these decisions and model the tax impact before choosing a structure.
What Is a Pass-Through Entity?
In simple terms, a pass-through entity is a business where the company itself does not pay federal income tax. Instead, profits and losses are allocated to the owners, who report them on their personal tax returns and pay tax at their individual rates. This is the defining characteristic that separates pass-through structures from C corporations, which are taxed separately at the entity level.
The term encompasses several different legal and tax structures. What they have in common that business income passes through to the owners, who report it on their individual tax returns.
Pass-through entities come in the following forms:
- Sole proprietorships: The simplest structure, where the owner and business are treated as the same tax entity. Business income and expenses are reported on Schedule C of the owner's personal return.
- Partnerships: Two or more individuals or entities jointly own and operate a business. Income is divided among partners per the partnership agreement and reported on Schedule K-1 and Schedule E.
- S corporations: A corporation that has elected special IRS tax treatment. It combines limited liability with pass-through taxation, though ownership is restricted to 100 shareholders who must meet specific eligibility criteria.
- Limited Liability Companies (LLCs): Flexible entities that offer personal liability protection while allowing pass-through taxation. A single-member LLC is treated as a disregarded entity by default; a multi-member LLC is treated as a partnership.
How Pass-Through Taxation Works
When a pass-through entity earns income, that income isn’t taxed at the business level. Instead, each owner receives an allocation of the business's income, deductions, gains, losses, and credits — proportional to their ownership interest — and reports it on their personal tax return.
Each owner’s share of the business income is taxed at that person’s individual tax rate, which depends on overall income. By contrast, C corporations typically pay tax on their profits first, and shareholders may owe tax again on dividend distributions.
Here is how federal income taxes are generally handled for each entity type:
- Sole proprietorships: Reported on Schedule C of the owner's Form 1040.
- Single-member LLCs: Same treatment as sole proprietorships by default.
- Partnerships: Income or loss flows to partners via Schedule K-1, reported on Schedule E.
- Multi-member LLCs: Treated as partnerships; members receive Schedule K-1.
- S corporations: Pass-through treatment applies, but filing requirements depend on the underlying entity structure since S corp status is an IRS election, not a business entity type.
Self-Employment Taxes
Sole proprietors and most general partners pay self-employment tax — currently 15.3% — on net business earnings. This covers Social Security and Medicare, and unlike employees, self-employed individuals cover the full amount themselves.
S corporation owners can reduce this exposure. Owners who work in the business pay self-employment taxes only on the wages the S corp pays them — not on distributions. This is one of the most common reasons profitable small businesses elect S corp status. The IRS requires that owner-employees receive reasonable compensation, and arrangements that shift too much income to distributions to avoid payroll taxes draw scrutiny.
Types of Pass-Through Entities: Pros, Cons, and Best Fit
There is no one-size-fits-all solution. The right structure depends on how many owners are involved, how much the business earns, whether liability protection matters, and how much administrative complexity you’re prepared to take on.
Sole Proprietorship
Best for: Freelancers, solopreneurs, and early-stage businesses testing a concept.
Advantages:
- Minimal paperwork and no formal filing requirements to establish;
- Full control over decisions and operations;
- Simple tax reporting via Schedule C.
Considerations:
- No liability protection — personal assets are exposed to business debts;
- Can be harder to raise capital or bring in partners later.
Partnership
Best for: Two or more owners who want flexible profit-sharing and management.
Advantages:
- Shared management and risk distribution among partners;
- Income allocation can be structured to optimize each partner's tax position.
Considerations:
- Partners are generally jointly liable for each other's actions;
- Disagreements between partners can create operational challenges without a solid partnership agreement.
S Corporation
Best for: Profitable owner-operated businesses where reducing self-employment taxes justifies the additional administration.
Advantages:
- Pass-through taxation with no double taxation;
- Owners can receive distributions not subject to self-employment taxes;
- Limited liability for shareholders.
Considerations:
- Strict ownership rules: no more than 100 shareholders, all must be U.S. citizens or residents;
- Requires regular meetings, recordkeeping, and ongoing compliance;
- Reasonable compensation requirements for owner-employees.
LLC
Best for: Most small businesses that want liability protection without corporate formality.
Advantages:
- Personal assets generally protected from business debts;
- Flexible management structure and profit-sharing arrangements;
- Pass-through taxation by default; can elect S corp or C corp treatment.
Considerations:
- Rules and fees vary by state;
- Multi-member LLCs require clarity on management roles to function smoothly.
LLC vs. S Corporation: Which Structure Fits Your Business?
This is one of the most common questions small business owners ask. The answer usually depends on income level.
An LLC taxed as a sole proprietor or partnership is simpler to operate. All net income is subject to self-employment tax. When a business reaches consistent profitability — typically somewhere between $40,000 and $50,000 in net income — electing S corp status can reduce that exposure. The business pays the owner a reasonable salary, which is subject to payroll taxes, while remaining profits may be distributed without being subject to self-employment tax.
The savings can be significant. But so can the additional costs: payroll processing, separate business returns, and stricter compliance requirements. The ideal breakeven point varies from one business to another, which is why this decision is best supported by professional tax modeling rather than a general rule of thumb.
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LLC or S Corp — Which One Saves You More?
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Advantages of Pass-Through Entities
Pass-through entities offer several meaningful advantages over C corporation structures, particularly for small and mid-size businesses.
- Avoidance of double taxation. In a C corporation, profits are taxed at the corporate level, then again when distributed as dividends. Pass-through entities avoid this entirely — income flows directly to owners and is taxed once.
- Flexibility in management. Sole proprietors, partners, and LLC members generally have wide latitude in how they run the business, without the formality requirements of a corporation.
- Simplified tax reporting. Rather than separate corporate and personal filings, pass-through income consolidates onto the owner's personal return.
- Qualified Business Income (QBI) deduction. Eligible pass-through owners may deduct up to 20% of qualified business income — see the section below for 2026 updates.
Potential Disadvantages
Pass-through structures are not always the right answer. Relevant drawbacks include:
- Self-employment taxes. Sole proprietors and partners pay the full 15.3% self-employment tax on net earnings, which can offset some of the income tax advantage.
- Limited access to certain tax incentives. Some deductions and credits available to C corporations do not apply to pass-through entities.
- Capital-raising limitations. Sole proprietorships and partnerships have fewer options for bringing in investors compared to corporations.
- S corporation ownership restrictions. The 100-shareholder cap and U.S. residency requirements can limit growth options.
- State-specific compliance. LLC rules, fees, and filing requirements differ across states, which matters for businesses operating in multiple jurisdictions.
Qualified Business Income (QBI) Deduction: 2026 Update
The QBI deduction under IRC §199A allows eligible pass-through owners to deduct up to 20% of qualified business income from taxable income. Originally introduced by the Tax Cuts and Jobs Act and set to expire after 2025, the One Big Beautiful Bill Act, signed July 4, 2025, made the deduction permanent and expanded access for more taxpayers.
Key changes for 2026:
- Deduction is now permanent — no sunset, no future uncertainty.
- Phase-out range expanded: Full deduction available below $201,775 (single) or $403,500 (married filing jointly). Phase-out extends to approximately $276,775 (single) or $553,500 (MFJ) — a wider window than in prior years.
- New minimum deduction: Taxpayers with at least $1,000 in qualified business income receive a minimum $400 QBI deduction starting in 2026.
- Specified Service Trade or Business (SSTB) limitation still applies: Businesses in fields such as law, accounting, healthcare, consulting, and financial services start to lose the deduction as income exceeds the phase-in thresholds.
- W-2 wage and property limitations apply for taxpayers above the threshold: the deduction is limited to the greater of 50% of W-2 wages paid or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.
As a CPA firm, Lewis.cpa is classified as an SSTB, which gives us firsthand experience with the deduction rules that impact many professional service businesses. If you're unsure whether your business qualifies, or how much you can deduct, our tax planning team can run the numbers.
Illinois Pass-Through Entity (PTE) Tax Election: 2026 Update
The Illinois PTE tax allows partnerships and S corporations to pay Illinois income tax at the entity level at a rate of 4.95%. The payment is deducted as a business expense on the federal return — bypassing the individual SALT deduction cap — and owners receive a corresponding credit on their Illinois returns.
Critical 2026 development: Illinois PTE election is now permanent. The original law included a sunset clause ending the election for tax years beginning on or after January 1, 2026. On December 12, 2025, Governor Pritzker signed SB 1911, removing the sunset provision entirely. Now, the election is available indefinitely, though the benefit analysis has shifted with the SALT cap increase under the OBBBA.
With the federal SALT cap raised from $10,000 to $40,400 for 2026, some business owners who previously relied heavily on the PTE election to bypass the cap may see reduced benefit. High-income owners, especially those with significant property taxes, may still see substantial benefits. The only way to know is to model your specific numbers.
Key mechanics of the Illinois PTE election:
- Rate: 4.95% of the entity's net income for the taxable year.
- Who can elect: Partnerships (excluding publicly traded partnerships under IRC 7704) and S corporations.
- Credit: Each partner or shareholder receives a credit equal to their share of the PTE tax paid.
- Estimated payments: Required if total expected tax exceeds $500; due on the 15th of the 4th, 6th, 9th, and 12th months of the tax year.
- Refunds: Entities that overpay PTE tax may request a refund.
- Forms: Election is made on Form IL-1065 (partnerships) or Form IL-1120-ST (S corporations).
Because the math shifted in 2026, the higher SALT cap reduces the automatic benefit of the election for some owners; this is a decision worth reviewing with a CPA before electing. Contact our team for a current analysis of whether the PTE election makes sense for your Illinois business.
How a CPA Can Help
Choosing a business entity isn’t a one-time decision. A business structure that worked well when you started may not be the best fit today, especially as income grows, ownership changes, or tax laws evolve, as they did in 2025 and 2026. A CPA can:
- Model the tax impact of different entity types based on your actual income;
- Evaluate whether an S corp election would reduce your self-employment tax exposure;
- Determine whether the Illinois PTE election makes sense for your specific ownership and income situation;
- Ensure QBI deduction eligibility is correctly calculated and documented;
- Identify when restructuring would create meaningful tax savings.
Lewis.cpa has worked with small business owners across Illinois and nationwide for nearly four decades. Whether you're starting a new business, reassessing your current structure, or preparing for a sale or transition, our small business accounting services team can run the analysis and explain what the numbers mean for your situation.
Lewis.cpa Helps Illinois Business Owners Choose and Optimize Their Entity Structure
The right business structure affects how much tax you pay every year, how you protect personal assets, and what options you have when the business grows or changes. Lewis.cpa has helped small and mid-size businesses across Illinois navigate these decisions since 1986.
Whether you're starting out, reconsidering your current structure, or evaluating the Illinois PTE election for 2026, our team can run a current analysis and give you a clear picture of what each option means for your situation. Contact us to schedule a consultation.
