Jun 16, 2021What is a flow-through entity?
Understanding the tax implications of a given business structure can be stressful. Is one structure superior to the rest? If you’ve already started operating, is it too late to switch? In most cases, the answer to these questions simply comes down to what you’re trying to accomplish. However, it never hurts to understand the pros and cons of each type. In this article, we’ll discuss what a “flow-through” entity is and walk through the advantages and disadvantages of using one.
What is a Flow-Through Entity?
A flow-through entity is a business entity where income flows directly to investors and owners for tax purposes. Adopting a flow-through structure allows a business to avoid paying corporate income tax on its earnings. Profits and losses are reported on the investors and owners personal tax returns.
Legal vs. Tax
It is important to note that a “flow-through” classification is based on the entity’s tax status rather than its legal designation. While legal structures are discussed in more depth in other articles, for our purposes it is enough to simply understand that each legal structure has a default tax status upon formation. For example, a company structured as a multi-member LLC (legal designation) has a default tax status of partnership.
Changing an entity’s tax status is possible in many cases, but it requires filing paperwork and adhering to restrictions set forth by the IRS. Understanding the default tax status, and the flexibility to change that status, is a critical factor in determining how to structure a business.
Examples of Flow-Throughs
The majority of small to mid-level businesses are taxed as flow-through entities. These types of entities include sole proprietorships, partnerships, S corporations, and disregarded entities. While each of these classifications have unique benefits and drawbacks individually, they all enjoy the same advantages of flow-through taxation.
On the other hand, C corporate status is the only tax status that is not considered a “flow-through”. Unlike other entities, C corporations pay corporate income tax at the entity level and again at the shareholder level. Typically, companies opt to become C corporations as they expand or prepare for an initial public offering.
Advantages of Flow-Throughs
No Double Taxation
The first major advantage of flow-through status is that shareholders and owners avoid double taxation. Double taxation occurs when income tax is assessed and paid twice on the same source of income. In the case of a C Corp, double taxation occurs when income is taxed both at the corporate level and at the individual level. Under current law, flow-through entities have an advantage over C Corporations because the total effective tax rate to shareholders and owners is lower. This is best illustrated with an example.
Let’s say that you are the sole owner of a business that earned $100,000 last year. For simplicity, also assume that you earn enough income from other sources to cause the entirety of your business earnings to fall into the top individual marginal tax rate of 37%. If your business were set up as a C Corporation, the $100,000 of earnings would first be subject to a 21% corporate income tax; leaving the business with $79,000 to distribute to shareholders. When the $79,000 of remaining income is distributed to you, the sole shareholder, you would be subject to an additional 23.8% (including NIIT) of capital gains tax equaling $18,802. After paying both levels of tax as a C Corp, your total income tax liability would be $39,802. Contrast this to a flow through entity where you would simply pay one level of tax at 37% equaling a total tax liability of $37,000.
Another major advantage of flow-through entities is the Qualified Business Income (QBI) Deduction. The QBI deduction was introduced in 2018 as part of the Tax Cuts and Jobs Act and allows business owners to deduct 20% of “qualified business income” on their personal tax return.
QBI includes most income from flow-through entities, with a few exclusions, such as wages paid to S Corp shareholders, guaranteed payments to partners, interest income, and dividends. Individuals whose annual taxable income exceeds $163,300 (in 2020) may be phased out or completely bared from this deduction, depending on total taxable income and the type of business the entity is involved in. If your taxable income exceeds this amount, consult with a tax professional to determine your QBI deduction amount.
Disadvantages of Flow-Throughs
One of the major disadvantages of pass-through entities is that most require business income to be recognized as earnings from self-employment. This simply means that earnings from flow-through entities are often subject to self-employment taxes. These taxes include Social Security and Medicare and are paid by the individual owner/shareholder.
It is important to note that self-employment tax is designed to function very similarly to payroll taxes paid by employees. This means that owners receiving distributions from business profits contribute essentially the same amount in self-employment taxes as they would contribute in payroll taxes if they were paying themselves a wage from the business. While subject to limitations, S Corporations are the only flow-through entity that might allow you to avoid paying self-employment tax on a portion of business income.
Owners Taxed on Earnings Regardless of Distributions
Another disadvantage of flow-through entities is that shareholders and owners are taxed on income as it is earned, regardless of whether that income is distributed in the form of cash. This creates an issue where individual owners may not have the wherewithal to pay their share of income taxes. Should a flow-through entity elect to retain all business profits within the business during the year, the owners would have to use other sources of income to produce the cash necessary to meet their tax liability.
Overall, flow-through entities are designed for private companies and are generally taxpayer friendly. If your business isn’t structured as a flow-through, it may be worth considering making a change with the IRS. Regardless, understanding the tax advantages of your business structure can result in significant tax savings.