Pass-Through Entities: Sole Proprietorships, Partnerships, and S Corps
Business entity selection is one of the most consequential tax planning decisions a business owner makes. The choice affects not only how income is taxed but also self-employment tax liability, state tax treatment, administrative complexity, and flexibility for future ownership changes. Understanding the tax characteristics of each major entity type is essential before choosing — and before evaluating whether restructuring an existing entity makes sense.
Sole proprietorships are the default form for single-owner businesses with no formal entity structure. All business income flows to the owner's Schedule C and is taxed as ordinary income at the owner's marginal rate. More importantly, all net self-employment income is subject to self-employment (SE) tax at 15.3% (the combined employee and employer share of Social Security and Medicare taxes) on the first $168,600 (2024) and 2.9% on income above that. The owner can deduct half of SE tax paid from gross income. For high-earning sole proprietors, SE tax is often the largest single tax cost.
Partnerships split income, losses, and credits among partners according to the partnership agreement and pass them through to each partner's individual return via Schedule K-1. Partners who are actively involved pay SE tax on their distributive share of self-employment income. Limited partners (passive investors) typically do not owe SE tax on their share. S corporations are the most commonly used entity for reducing SE tax: an S corp pays its owner-employee a "reasonable salary" (subject to payroll taxes) and distributes remaining profits as shareholder distributions (not subject to SE tax). The tax savings from shifting compensation from salary to distributions can be substantial, but the IRS scrutinizes S corp salary levels — setting salary too low relative to distributions is a red flag for audit.