What Is a Flow-Through Entity?
A flow-through entity is a legal business entity that passes income on to the owners and/or investors of the business. Flow-through entities are a common device used to limit taxation by avoiding double taxation. Only the investors or owners are taxed on revenues, not the entity itself.
- A flow-through (pass-through) entity is a legal business entity that passes income on to the owners and/or investors of the business.
- Flow-through entities are a common device used to limit taxation by avoiding double taxation.
- With flow-through entities, the income is taxed only at the owner's individual tax rate for ordinary income.
Understanding a Flow-Through Entity
The income generated by a flow-through entity is treated as income of the investors or owners. This means that taxation passes through to the tax return of owners, and so flow-through entities are considered non-entities for tax purposes because they are not taxed.
A flow-through entity is also known as a pass-through entity.
Businesses that are set up as flow-throughs are not subject to corporate income tax. Instead, they pay taxes on business income as though the income is personal income. In addition, the owners can apply losses of the company against their personal income. Although flow-throughs are considered non-entities for tax purposes, U.S. law still requires flow-through entities to file an annual K-1 statement.
Although flow-through businesses generally face the same tax rules as C corporations for inventory accounting, depreciation, and other provisions affecting the measurement of business profits, both business entities differ in that flow-through entities are taxed only once.
C corporations, on the other hand, are subject to double taxation—income is taxed at the corporate tax rate first and then taxed again when paid out as dividends to shareholders or when shareholders realize capital gains arising from retained earnings. With flow-through entities, the income is taxed only at the owner’s individual tax rate for ordinary income.
Types of Flow-Through Entities
Flow-through entities are commonly grouped into sole proprietorships, partnerships (limited, general and limited liability partnerships) and S Corporations, along with income trusts and limited liability companies. A sole proprietor reports all his or her business income in her personal income tax return. The Internal Revenue Service (IRS) considers this form of taxation as a flow-through given that the business is not taxed separately.
S corporations have profits flow through to shareholders who report the income on Schedule E of their personal income tax. Although S corporation owners do not pay the Self-Employed Contributions Act (SECA) tax on their profits, they are required to pay themselves "reasonable compensation," which is subject to the regular Social Security tax. In Canada, a flow-through entity includes an investment corporation, a mortgage investment corporation, a mutual fund corporation, a partnership, or a trust.
The Disadvantages of Flow-Through Entities
One important potential downside to a business that elects to operate as a flow-through entity is that the owners will still be taxed on income that they do not directly receive. For instance, with this type of structure, a company's owners and/or investors will be taxed on the business's income, even if the business does not distribute its profits to owners in the form of dividends.