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How are pass-through and corporate tax rates different?
What businesses are pass-through entities?
Pass-through entities include the following:
They’re called this because you pass their income through to your individual tax forms. In other words, the corporate tax rate does not apply. Instead, you pay personal tax rates on your business income.
Does your tax bracket apply to all of your income?
“The incremental tax system basically taxes your income in buckets,” Standberry says. “In order to get taxed at the next rate you have to fill the first bucket up.”
That first bucket is the 10% bracket. That applies to the first $12,400 of your taxable income, which includes business income for pass-through entities. The second bucket is the 12% bracket. It applies to every dollar between $12,401 and $50,400 and so on per the brackets below.
Federal income tax rate
Taxable income amount
10%
Up to $12,400
12%
$12,401 to $50,400
22%
$50,401 to $105,700
24%
$105,701 to $201,775
32%
$201,776 to $256,225
35%
$256,226 to $640,600
37%
$640,601 and up
Let’s say you’re a sole proprietor who pays taxes as a single filer. You make $150,000 after deductions.
The IRS taxes the first $12,400 of your income at the lowest rate: 10%. That comes out to $1,240 (0.10 x 12,400) in taxes.
It taxes the next $38,000 ($50,400 – $12,400) at 12%. That adds another $4,560 (0.12 x 38,000) to your tax bill.
The cap on the next tax bracket is $105,700. That means the IRS taxes $55,300 (105,700 – 50,400) at 22%. That comes out to an additional $12,166 (0.22 x 55,300) in taxes.
You’ll owe 24% on your remaining income: $44,300 (150,000 – 105,700). That equals an extra $10,632 (0.24 x 44,300) in taxes.
In this case, your total federal income tax payment would be the sum of those numbers. That makes for a total tax bill of $28,598 (1,240 + 4,560 + 12,166 + 10,632).
Can you reduce your tax rate?
Yes. Deductions are one way to decrease your taxable income amount. This could land you in a lower tax bracket.
Just make sure you can back up the expenses you deduct.
Saleh helps clients navigate IRS audits. She says your deductions should tell a story in case the IRS investigates them.
“You want it all to align,” she says. “You don’t want to rely on bank statements and credit card statements.”
Some LLCs and sole proprietorships may also be able to reduce their tax liability by becoming an S corporation. This eliminates the 15.3% self-employment tax. But it adds complexity.
“A lot of times taxpayers don’t follow the rules with S corporations,” Saleh says. “And that also gets them into trouble.”
For instance, you’ll need to pay yourself “reasonable compensation.” The IRS doesn’t define what’s “reasonable,” though. You need to figure that out, and you can face tax penalties for getting it wrong.
Regardless, don’t wait until tax season to think about ways to legally minimize your taxable income.
“If you want to reduce your taxes, you need to do something before December 31,” Standberry says. That way, you can come up with a strategy ahead of time.
Saleh also recommends making sure your risk tolerance aligns with your accountant’s strategy. Deciding what to deduct should be a team effort — not something you completely hand off.
What are marginal and effective tax rates?
CPAs like Standberry focus on marginal rates when they’re trying to reduce a business’s tax liability.
“If I’m in a 37% marginal tax bracket, I’m trying to take that 37% portion of income and see if I can reduce it,” he says. “Because that’s going to save them [his clients] 37 cents on the dollar.”
But it’s important to know your effective tax rate because that represents “what you’re forfeiting out of your income,” Standberry says.
Knowing this gives you a better idea of how much cash you should plan on setting aside for tax payments. From there, you can budget accordingly.
To find your effective rate, divide your total federal income tax bill by your taxable income.
Marginal vs. effective tax rate example
Let’s return to the situation above. You’re a sole proprietor who makes $150,000 per year after deductions. Your marginal tax rate for 2026 would be 24%. The IRS applies that rate to income between $105,701 and $201,775.
To find your effective tax rate, divide your tax bill ($28,598) by your taxable income ($150,000). That comes out to about 19% [(28,598 / 150,000) x 100].
About the author
Hillary Crawford is a small-business writer at NerdWallet, with a special focus on business software products. Her previous roles include news writer and associate West Coast editor at Bustle Digital Group, where she helped shape news and tech coverage. Her work has appeared in The Associated Press, The Washington Post, Yahoo Finance and Entrepreneur, in addition to other publications. She is based in Traverse City, Michigan.
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