How LLC Pass-Through Taxation Works in 2026
Pass-through taxation is the defining tax characteristic of most LLCs. Unlike C-Corporations, which pay corporate income tax on their profits, pass-through entities do not pay tax at the entity level. Instead, all income, losses, deductions, and credits "pass through" to the owners' personal tax returns.
This avoids the double taxation problem faced by C-Corps (where profits are taxed once at the corporate level and again when distributed as dividends). For most small to mid-size businesses, pass-through taxation results in a lower overall tax burden.
Pass-Through Entities: LLCs (default), partnerships, S-Corporations, and sole proprietorships are all pass-through entities. Only C-Corporations pay tax at the entity level. An LLC can choose any of these classifications, but the default (and most common) is pass-through.
The 20% QBI Deduction (Section 199A)
The most significant tax benefit of pass-through taxation is the Qualified Business Income (QBI) deduction, enacted under Section 199A of the Tax Cuts and Jobs Act. This deduction allows eligible LLC owners to deduct up to 20% of their qualified business income, effectively reducing the top marginal rate on pass-through income from 37% to 29.6%.
How the QBI Deduction Works
- Calculate your qualified business income (net income from a qualified trade or business)
- Calculate 20% of QBI
- Calculate 20% of your taxable income (before QBI deduction) minus net capital gains
- Your QBI deduction is the lesser of these two amounts
Income Thresholds for 2026
| Filing Status | Full Deduction Below | Phase-Out Range | No Deduction (SSTB) Above |
|---|---|---|---|
| Single | $191,950 | $191,950 - $241,950 | $241,950 |
| Married Filing Jointly | $383,900 | $383,900 - $483,900 | $483,900 |
| Married Filing Separately | $191,950 | $191,950 - $241,950 | $241,950 |
| Head of Household | $191,950 | $191,950 - $241,950 | $241,950 |
Specified Service Trades or Businesses (SSTBs)
The QBI deduction treats certain service businesses differently. Specified service trades or businesses (SSTBs) face complete phase-out of the deduction above the income thresholds. SSTBs include:
- Health: Doctors, dentists, nurses, veterinarians, physical therapists
- Law: Attorneys, paralegals, legal support services
- Accounting: CPAs, bookkeepers, enrolled agents
- Actuarial Science
- Performing Arts: Actors, musicians, entertainers
- Consulting: Management consultants, business advisors
- Athletics: Professional athletes, coaches
- Financial Services: Financial advisors, investment managers, wealth management
- Brokerage Services
- Reputation or Skill: Any business where the principal asset is the reputation or skill of one or more employees/owners
Not SSTBs: Engineering, architecture, real estate, manufacturing, retail, restaurants, construction, technology (product companies), e-commerce, and most other businesses are not SSTBs. These businesses can claim the full QBI deduction at any income level, though above the threshold, the deduction is limited to the greater of: (a) 50% of W-2 wages paid, or (b) 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.
QBI Deduction Examples
| Scenario | QBI | Taxable Income | QBI Deduction | Tax Savings (24% bracket) |
|---|---|---|---|---|
| Freelancer (non-SSTB) | $80,000 | $65,000 | $13,000 | $3,120 |
| Consultant (SSTB, under threshold) | $120,000 | $105,000 | $21,000 | $5,040 |
| Law firm (SSTB, in phase-out) | $200,000 | $220,000 | Reduced | Varies |
| Retailer (non-SSTB, high income) | $300,000 | $350,000 | $60,000* | $14,400 |
*Subject to W-2 wages and qualified property limitations above the threshold.
Pass-Through vs C-Corp Tax Comparison
| Feature | Pass-Through (LLC/S-Corp) | C-Corporation |
|---|---|---|
| Entity-level tax | None | 21% corporate rate |
| Owner-level tax on profits | 10-37% individual rates | 0-20% dividend rate |
| Double taxation | No | Yes (corporate + dividend) |
| QBI deduction available | Yes (up to 20%) | No |
| Effective top rate | 29.6% (with full QBI) | 39.8% (21% + 23.8% on dividends) |
| Loss pass-through | Yes | No (trapped at corporate level) |
| Retained earnings | Taxed to owners regardless | Taxed at 21% only |
State Pass-Through Entity Tax (PTET) Elections
Many states now offer Pass-Through Entity Tax elections that allow LLCs to pay state income tax at the entity level. This is a workaround for the federal $10,000 SALT deduction cap:
- The LLC pays state tax at the entity level (deductible against federal income as a business expense, not limited by SALT cap)
- Members receive a state tax credit on their personal returns
- Net effect: federal deduction for state taxes that would otherwise be limited by the SALT cap
- Available in 36+ states including California, New York, New Jersey, Connecticut, Illinois, and many more
States with PTET Elections
Most states now offer some form of PTET. Key states and their rates:
- California: 9.3% PTET rate, annual election
- New York: 6.85-10.9% graduated rates
- New Jersey: 5.675% for income up to $250K, up to 10.75%
- Connecticut: 6.99% mandatory for most PTEs
- Illinois: 4.95% flat rate
- Georgia: 5.39% flat rate
Net Investment Income Tax (NIIT) and Pass-Through Income
The 3.8% Net Investment Income Tax (NIIT) generally does not apply to active pass-through business income:
- Material participation: If you materially participate in your LLC business, your share of income is exempt from NIIT
- Passive income: If you are a passive investor in an LLC, your share may be subject to NIIT
- Threshold: NIIT only applies if your modified AGI exceeds $200,000 (single) or $250,000 (MFJ)
- Rental income: Generally passive and subject to NIIT (exception for real estate professionals)
Maximizing Pass-Through Tax Benefits
- Claim the QBI deduction: File Form 8995 (simplified) or 8995-A (standard) to claim the 20% deduction
- Manage taxable income: If near the SSTB threshold, consider timing strategies (defer income or accelerate deductions)
- Elect PTET if available: Particularly valuable in high-tax states for SALT cap workaround
- Consider entity structure: Separating SSTB and non-SSTB activities into different LLCs may preserve QBI deductions
- Pay W-2 wages: For non-SSTB businesses above the threshold, paying W-2 wages increases the QBI deduction limit
- Invest in qualified property: Tangible depreciable property increases the alternative QBI deduction limit