Flow-through Entities – What are they? Why should you care?
Small business owners have several options on how to organize their business for tax purposes. Many small, single owner, businesses are not incorporated, and are deemed “sole proprietors,” in the eyes of the IRS. Other business entities, like C-Corporations, are taxed as a separate entity with distributions to owners taxed a second time as dividends. Still others are deemed “flow-through” entities like S-Corporations and Limited Liability Companies (LLC).
Flow-through entities do not pay taxes at the company level. Instead, the business tax return reports the net income to the IRS, but then distributes the taxable income to their respective owners via a K-1 tax form. Each individual owner then reports their share of the K-1 net income on their individual tax return and pays the tax on this and any other personal income.
Generally, business owners like flow-through entities because:
- The business income is taxed once instead of twice as in the case of C-Corporations.
- The business format provides owners a level of legal protection that is not available by doing business as a sole proprietor.
What you should know
- Individual tax rates. Increases in individual tax rates have an impact on the amount of tax paid by all small businesses that are organized as flow-through entities.
- Can you pay the tax? Small “flow-through” businesses must pay income tax on all their business profits. However, the business entity is NOT required to distribute cash from the company to help pay the tax. So “flow-through” owners could see a tax bill without money to pay the tax.
- Seasonality challenge. Seasonal “flow-through” businesses with high sales volumes in the summer often have a hardship to pay their taxes. This is because cash for these businesses is typically used to build inventory at the same time taxes are due.
- Minority shareholder caution. Minority Shareholders in “flow-through” entities are doubly cursed. They not only may not receive distributions to pay taxes due, but they are often precluded from selling their shares, and they do not have enough ownership to require distribution of funds through shareholder voting.
- The marriage penalty. Taxes on your business income can be higher for a married couple versus a single business owner. This is due to the pre-built tax rate penalty for married couples in the current tax code.
- Very popular business entity type. According to the IRS the S-Corporation formation is a popular business entity type with over 4.2 million S-Corporations on record. LLC’s are quickly becoming the new entity of choice with growth from 250,000 entities to over 1 million entities today.