A flow-through entity is a legal business structure where any income generated is transferred directly to its owners, shareholders, or investors. Consequently, only these individuals—rather than the entity itself—are taxed on the revenues. Flow-through entities are a strategic way to avoid double taxation typically experienced by regular corporations.
Key Insights
- A flow-through (or pass-through) entity passes all its income to its business owners or investors, avoiding double taxation.
- Income from these entities is taxed solely at the owners’ individual tax rates rather than at a corporate tax rate.
- Examples of flow-through entities include sole proprietorships, partnerships (limited, general, and limited liability partnerships), LLCs, and S Corporations.
- Owners can be taxed on earnings they do not actually receive, which is a notable downside.
Understanding Flow-Through Entities
Both businesses and individuals are taxable entities—liable for taxes on their earnings. Individuals pay income tax on wages, while companies pay corporate tax on revenues. However, businesses established as flow-throughs bypass corporate income tax. Instead, the income is treated as personal income for the investors, stockholders, or owners. Consequently, earnings pass—or flow through—to individuals, transferring tax liability along with them.
These stakeholders then pay taxes on the business income at their individual income rates. This setup also allows owners to offset business losses against personal income. Though flow-through businesses broadly adhere to the same tax rules as C corporations for inventory accounting and depreciation, they effectively face only one level of taxation. In contrast, C corporations deal with double taxation: income is taxed at both corporate and individual levels when distributed as dividends.
Types of Flow-Through Entities
Flow-through entities come in various forms including sole proprietorships, partnerships (limited, general, and limited liability partnerships), S Corporations, income trusts, and limited liability companies.
- Sole Proprietorships: The owner reports business income on their personal tax return, and the IRS categorizes it as a flow-through since the business itself isn’t separately taxed.
- S Corporations: Profits are reported by shareholders on their personal tax returns. While they avoid the Self-Employed Contributions Act (SECA) tax on profits, owners must ensure they pay themselves
Related Terms: sole proprietorships, partnerships, income trusts, corporate tax, self-employment tax.
References
- Tax Policy Center. “What are Flow-Through Enterprises and How Are They Taxed?”, Page 1.
- Internal Revenue Service. “Forming a Corporation”.
- U.S. Small Business Administration. “Choose a Business Structure”.
- Internal Revenue Service. “About Schedule E (Form 1040), Supplemental Income and Loss”.
- Internal Revenue Service. “S Corporation Compensation and Medical Insurance Issues”.
- Government of Canada Revenue Agency. “What Is a Flow-Through Entity?”
- Internal Revenue Service. “Tax Information For Partnerships”.
- Internal Revenue Service. “S Corporations”.
- Internal Revenue Service. “Topic No. 404, Dividends”.
- Internal Revenue Service. “Sole Proprietorships”.
- Internal Revenue Service. “Single Member Limited Liability Companies”.
- Internal Revenue Service. “Limited Liability Company (LLC)”.
