Understanding Flow-Through Entities: Types, Advantages & Disadvantages

What Is a Flow-Through Entity?

A flow-through entity is a legal business that passes any income it makes straight to its owners, shareholders, or investors. Only these individuals and not the entity itself are taxed on the revenues as a result. Flow-through entities help avoid double taxation, a common issue with income from regular corporations.

Flow-through entities are sometimes called disregarded entities because the IRS ignores them for tax purposes. Their owners, shareholders, and investors pay taxes on the income that flows or passes through to them instead.

Detailed Overview of Flow-Through Entities

Both businesses and individuals are taxable entities. They're liable to pay taxes on the money they earn.

Individuals pay income tax on their wages and companies pay corporate tax on their revenues but businesses that are set up as flow-throughs aren't subject to the corporate income tax. The income generated by a flow-through or a pass-through entity is instead treated solely as income of the investors, stockholders, or owners. Earnings directly pass or "flow through" to the individuals and so does the tax liability.

These individual stakeholders pay taxes on business income as though it is personal income and it's taxed at their ordinary income rate. The owners can also apply losses of the company against their personal income.

Flow-through businesses generally face the same tax rules as C corporations for inventory accounting, depreciation, and other provisions that affect the measurement of business profits but they're effectively taxed only once. Earnings generated by C corporations are subject to double taxation. Income is taxed at the corporate rate first and it's then taxed again when it's paid out as dividends to shareholders or when shareholders realize capital gains from retained earnings.

Common Forms of Flow-Through Entities

Flow-through entities are commonly grouped into sole proprietorships, S corporations, income trusts, and limited liability companies. They can also be limited, general, and limited liability partnerships.

A sole proprietor reports all their business income on their personal income tax return. The IRS considers this form of company to be a flow-through given that the business isn't taxed separately.

S corporation profits flow through to shareholders who report the income on Schedule E of their personal tax returns. S corporation owners don't pay the Self-Employed Contributions Act (SECA) tax on their profits but they're required to pay themselves "reasonable compensation" which is subject to the regular Social Security tax.

A flow-through entity can be an investment corporation, a mortgage investment corporation, a mutual fund corporation, a partnership, or a trust in Canada.

Benefits of Choosing a Flow-Through Entity Structure

The greatest advantage of a flow-through or pass-through entity is tax treatment.

Incorporated businesses pay corporate income tax on profits before distributing them to shareholders, who then report dividends on personal tax returns, causing double taxation.

A flow-through entity allows profits to avoid the initial corporate tax round. A flow-through is exempt from business taxes. It passes earnings straight through to stakeholders who will owe taxes on that money but the money is taxed only once.

Some flow-through entities offer additional tax deductions for owners and investors. It also gets passed through if the business suffers a loss and can be used to reduce overall taxable income.

Potential Drawbacks of Flow-Through Entities

A downside of flow-through entities is that owners are taxed on income even if they don't receive distributions. Investors must report their share of profits, and they may owe taxes even if profits are reinvested, not distributed.

Some pass-through entities' owners may also become subject to self-employment tax when they avoid corporate tax.

The Bottom Line

Flow-through entities can save you from double taxation on a company's profits. Sole proprietorships, partnerships, LLCs, and S corps can take advantage of pass-through taxation but it's possible for owners of or investors in a pass-through entity to be taxed on income they didn't receive. This can happen if the income is put back into the business.

Some flow-through entities such as sole proprietors are also subject to self-employment tax so it's important to understand the tax implications of your situation.