If you’re exploring different ways to structure your business, you may have come across something called a flow-through, or pass-through, entity. A flow-through entity is a business in which income is passed straight to its shareholders, owners, or investors. As a result, only the individuals, not the business, are taxed on the revenue — thereby avoiding double taxation.
Curious as to how flow-through entities work and whether or not one is right for you? This guide will explore some of the advantages and drawbacks of establishing this type of legal entity.
[Read more: How to Choose a Legal Entity for Your Startup]
How does a flow-through entity work?
Businesses and individuals are both considered taxable entities, meaning that they must pay the IRS based on the money they earn. Businesses pay a corporate tax on revenues; individuals pay an income tax on their wages.
However, the issue of double taxation can cause some individuals to pay tax on the same income twice. Double taxation takes place because corporations are considered separate entities from their shareholders.
“As such, corporations pay taxes on their annual earnings, just like individuals. When corporations pay out dividends to shareholders, those dividend payments incur income-tax liabilities for the shareholders who receive them, even though the earnings that provided the cash to pay the dividends were already taxed at the corporate level,” explained Investopedia.
To avoid this double taxation problem, some businesses are set up as pass-through entities. Income that’s generated by these entities is treated as the income of the investors or shareholders. These individuals pay taxes on business income as if it’s their wages, taxed at their ordinary income tax rate.
The biggest drawback to a flow-through entity is that individuals may face a higher tax burden.
Types of flow-through entities
There are three main types of flow-through entities:
- Sole proprietorship: a business owned and operated by a single individual.
- Limited liability corporation (LLC): an entity in which partners are not personally liable for the company’s debt obligations.
- S corporation (S corp): a form of LLC in which ownership is limited to certain individuals, trusts, and estates, and less than 100 shareholders.
In addition to avoiding the issue of double taxation, LLCs and S corps also protect the business owner from risk — especially financial risk. “Individuals generally cannot use the income earned through a source to offset losses from another. However, shareholders of a flow-through entity can deduct business losses from their personal incomes coming through other sources,” wrote the Corporate Finance Institute.
The biggest drawback to a flow-through entity is that individuals may face a higher tax burden. As the business owner, even if you do not retain profit or pay yourself a dividend, you will be liable to pay taxes on that dividend or profit because it’s a flow-through entity. Be aware that your personal taxes may be much higher than you anticipate with a flow-through structure.
[Read more: Still Not Clear on the New Tax Laws? Here's How They'll Affect Your Business]
How to establish a flow-through entity
If you decide that a flow-through business entity is right for you, the next step is to choose whether you will establish an LLC, S corp, or sole proprietorship. Then, when it comes time to do your taxes, the filing process involves the following steps:
- Calculate taxable business income before owner’s compensation.
- Divide taxable income according to ownership percentages (e.g., if you own 100% of your business, you will be taxed on 100% of the income).
- Report your share of the business income on tax Form 1040.
- Pay taxes based on this personal taxable income.
There may be other tax forms that you need depending on the type of business entity you elect. For instance, S corps need to provide IRS Form 1120-S, an information return.
Most flow-through entities, including most LLCs, are subject to IRS self-employment tax — 15.3% of your earnings, according to the Motley Fool. Likewise, you will also need to pay state and local taxes as applicable.
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