Business and Pass-Through Income

The entity you operate through does not change how much you earn. It changes how much of it is exposed to the 15.3% self-employment tax — which is the single largest tax-structure decision most business owners will make.

Partnership and LLC distributive share

A general partner’s or actively-participating LLC member’s share of trade-or-business income is self-employment income under IRC §1402(a), “Net earnings from self-employment”, reported on Schedule K-1 and carried to Schedule SE. A limited partner’s share is generally excluded under §1402(a)(13) — the provision the IRS has been aggressively litigating against fund managers and professional LLCs who claim limited status while working full-time in the business. Do not assume the exclusion; document the participation.

S corporation distributive share

Here is the difference that matters. An S corporation shareholder’s distributive share is not self-employment income (Rev. Rul. 59-221) — only the W-2 wage the corporation pays you is. Pay yourself $150,000 of reasonable compensation out of $400,000 of profit and the remaining $250,000 escapes the 2.9% Medicare component and the 0.9% surtax entirely. It escapes more than that: with the 2026 wage base at $184,500, the salary leaves $34,500 of Social Security headroom unused, so the distribution also dodges 12.4% on that slice — roughly $4,300 that a sole proprietor on the same profit would have paid.

This is legal, common, and the most heavily audited position in small-business tax. The word carrying all the weight is reasonable: the IRS will recharacterize distributions as wages where compensation is implausibly low for the services performed, and it has won repeatedly. Benchmark the salary against what you would pay someone else to do your job, and document the benchmark contemporaneously.

The §199A deduction

Both structures may qualify for the 20% Qualified Business Income (QBI) deduction under IRC §199A, “Qualified business income”, made permanent by the OBBBA. It is a deduction against taxable income rather than an exclusion, it phases out for specified service businesses above income thresholds, and it interacts with the wage-and-property limitation — which means the S-corp wage you just minimized for payroll-tax reasons may be the wage you need to maximize to preserve the deduction. Model both together, not sequentially.

Hobby Income

Income from an activity not engaged in for profit under IRC §183, “Activities not engaged in for profit”. Reported on Schedule 1 and not subject to self-employment tax — which is the giveaway that it is not really compensation for services at all. The sting is on the deduction side: IRC §67(g) suspended miscellaneous itemized deductions, and the OBBBA made that suspension permanent, so hobby expenses are simply gone. You are taxed on gross receipts with no offset for what you spent earning them. If the activity is genuinely profit-motivated, establish that with the nine factors of Treas. Reg. §1.183-2(b) before the IRS decides for you.