A partnership or S-corporation passes its income through to the owners' individual returns. There is no entity-level federal tax on the operating income. The Scholar who owns a stake in a pass-through should understand the K-1 and the timing consequences of the pass-through structure.
- 01Read a Schedule K-1 at a working level.
- 02Distinguish an active from a passive interest for tax purposes.
- 03Explain the qualified business income deduction under §199A.
How it flows
The entity files an information return (1065 for partnerships, 1120-S for S-corps). Each owner receives a K-1 showing their share of income, deductions, and credits. That share is reported on the owner's Form 1040 and taxed at the owner's marginal rate. There is no federal tax at the entity level.
Active versus passive
The active/passive distinction determines whether losses can offset ordinary income. Material participation — measured by hours and involvement — is the test. A poorly documented active interest defaults to passive under audit, and passive losses are trapped until there is passive income to absorb them.
§199A
The qualified business income deduction lets many pass-through owners deduct up to 20% of QBI from their taxable income. Phase-outs and specified-service-trade rules make the calculation complex. The deduction is scheduled to expire after 2025 absent legislation.
- The entity does not pay tax; the owner does.
- Active or passive is a facts-and-circumstances test — document.
- §199A is worth 20% of QBI for most operating pass-throughs. Learn its limits.