What Is a Flow-Through (Pass-Through) Entity, Types, Pros & Cons

What Is a Flow-Through Entity?

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

Key Takeaways

  • A flow-through (pass-through) entity is a legal business entity that passes all its income on to the owners or investors of the business.
  • Flow-through entities are a common device used to avoid double taxation on earnings.
  • With flow-through entities, the income is taxed only at the owner's individual tax rate for ordinary income: The business itself pays no corporate tax.
  • Sole proprietorships, partnerships (limited, general, and limited liability partnerships), LLCs, and S Corporations are all types of flow-through entities.
  • One downside of flow-throughs: Owners can be taxed on income that they do not actually receive.

Understanding a Flow-Through Entity

Both businesses and individuals are taxable entities—that is, 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 are not subject to corporate income tax. Instead, the income generated by a flow-through entity, aka a pass-through entity, is treated solely as income of the investors, stockholders, or owners. Any 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 is taxed at their ordinary income rate. In addition, the owners can apply losses of the company against their personal income.

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, they are in effect taxed only once. Earnings generated by 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.

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 their business income on their personal income tax return. The Internal Revenue Service (IRS) considers this form of company 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.

Although flow-throughs are considered non-entities for tax purposes, they are still required to file an annual K-1 statement, as regular public companies do.

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, if the business does not distribute its profits to owners in the form of dividends, but plows them back into the company, the investors are still required to report their share of the profits, and could owe taxes on them.

Also, while they avoid corporate tax, some pass-through entities' owners may be subject to self-employment tax.

Pass-Through Entity FAQs

Is a Flow-Through Entity the Same as a Pass-Through Entity?

Yes, a flow-through entity is the same as a pass-through entity.

What Is the Advantage of a Pass-Through Entity?

When it comes to the big advantage of a pass-through entity, we have two words for you: tax treatment.

Regular incorporated businesses pay a flat corporate income tax on any profits before they distribute those earnings to stockholders and owners. These shareholders must report their dividends or other distributions on their personal tax returns. So the same dollars effectively get taxed twice.

A pass-through entity allows profits to avoid this double taxation—specifically, the initial corporate tax round. A pass-through is exempt from business taxes. It passes earnings straight through to stakeholders, who do owe taxes on it. But the money is only taxed once.

A pass-through entity also affords owners and investors an extra deduction on their personal taxes in some cases. If the business suffers a loss, that also gets passed through and can be used to reduce overall taxable income.

What Business Entity Is Not Considered a Pass-Through Entity?

A C Corporation is a common business entity that is not considered a pass-through entity.

Does a Disregarded Entity Pay Taxes?

Yes, a disregarded entity pays taxes. But since by definition it's usually a single-person business or company, it's not treated or taxed separately from its owner by the IRS. It reports its income on the owner's personal tax return.

Disregarded entities pay two types of taxes, similar to sole proprietorships:

  • Self-employment tax (a flat rate)
  • Income tax (variable rate, depending on the individual owner's tax bracket)

Is a Single-Member LLC Automatically a Disregarded Entity?

Yes, a single-member LLC is automatically a disregarded entity. It can request to be taxed differently.

Can a Disregarded Entity Have Employees?

Yes, a disregarded entity can have employees. The "disregarded entity" status is recognized only for the purposes of federal income taxes; it doesn't affect employment—and in fact, a disregarded entity with workers might have to pay employment taxes. 

However, the IRS and courts have ruled that a single-member LLC, one of the most common types of disregarded entities, cannot classify an owner as both an employee and a partner.

Article Sources
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