Partnerships are referred to as flow-through entities. What does that mean for the entity and its owners? Are there other flow-through entities besides partnerships? Is there an advantage to being an owner of a flow-through entity?
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Under a flow-through entity all income is passed on to the owners and/or investors of the business. This method is used to avoid double taxation on earnings. With the flow-through entity, the business pays no corporate taxes. Income is taxed at the owner’s individual tax rate for ordinary income only. Other types of flow-through entities include S corporation, income trust, limited liability companies, sole proprietorships, limited liability and general partnerships. In addition to avoiding double taxation, losses from the company can be applied to the owner’s personal income. Many businesses choose to operate as a flow-through entity because of those advantages.
A flow-through entity is one where all of the income of the organization is passed through to its owners for tax reporting purposes. There are various types of flow-through entities to include partnerships, as well as LLCs, S-Corps, and sole proprietorships.
The biggest advantage of a flow-through entity is the avoidance of double-taxation that sometimes occurs in other types of entities. In non-flow-through-entities, such as C-Corps, the corporation pays a tax on its revenue and any owners are required to pay individual tax rates on their income and share earnings as well. For flow through entities, the corporation itself does not pay tax on its revenues. The taxes for the corporation “flow through” the owner(s) individual tax filings and are paid on the individual level. The owner(s) can also claim business revenue losses on their personal income taxes, as a result.
The disadvantage of this type of tax structure is that sometimes the owner(s) of a flow-through corporation might not actually see the income they have to pay taxes on. Sometimes that money gets put back into the organization instead of going in the individual owner(s) pocket(s) but they are still taxed for it.
Hayes, A. (2021, June 03). Flow-Through Entities: What You Need to Know. Retrieved June 4, 2021, from https://www.investopedia.com/terms/f/flow-through.asp
Flow-through entities are entities by which the profits and losses ‘flow-through’ to the owners of the entity. In addition to Partnerships, LLCs (not electing to be treated as a c-corporation for tax purposes) and sole proprietorships also pass entity earnings to their owners. S-Corporations, which are incorporated businesses with less than 100 employees (with a few other limitations), also elect to pass their earnings to their shareholders, even though the entity itself chooses to operate like a corporation, a legally separate entity from its owners.
The prime advantage of flow-through income to entity owners is the avoidance of double taxation. For example, C-Corporations are required to pay taxes on it’s own earnings (21% for 2021), which can be at higher rates than some shareholder’s marginal income tax rates. In addition to corporate income taxes, earnings that are distributed to its owners are taxed again as dividend income to the recipients, aka shareholders. Allowing (or electing) income to flow-through to owners avoids the additional divided tax, which ranges from 0% – 20% based on marital/filing status and income levels. In short, an owner of a C-Corp could be on the hook for a 41% marginal tax rate! The highest marginal tax rate for married/joint is only 37%, assuming income passes through without dividends. So, when tax planning makes sense, choosing a flow-through entity may provide a lower overall tax bill, self-employment-tax considerations not-withstanding
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