Most businesses in the United States are organized as pass-through businesses, such as sole proprietorships, partnerships, limited liability companies and S corporations. According to the Brookings Institution, about 95 percent of businesses fall into that category. These entities are called pass-throughs, because their profits are passed directly through the business to the owners and are taxed on the owners’ individual income tax returns. Income earned by a business organized as a pass-through entity must be distributed as taxable income to its owner, members or partners. The pass-through entity itself doesn’t pay income taxes, but it also can’t defer tax on profits to be used later to reinvest in the business. Instead, all of its income is distributed each year to the individuals who own the pass-through entity, and they must pay tax on the profits.
This is in contrast with traditional C corporations, which pay tax at the entity level through the corporate income tax. Their owners (shareholders) then pay tax on this income again when they receive a dividend or sell their stock and realize a capital gain. Another difference between pass-through businesses and traditional C corporations is that owners of pass-through businesses pay the full tax on their business’s income every year as the business earns it. Contrast this with owners or shareholders of C corporations, who can defer the taxation on their share of corporate income as long as the corporation retains its earnings or if the shareholder does not realize a capital gain on his stock.