What is a flow-through entity?

What is a flow through (also called a pass through) entity?

A lot of times when people think about a business, they think corporations. They think these businesses (these corporations) themselves pay corporate taxes. But, not all businesses are corporations. And, even those that are corporations can be different types of corporations.

Yes, there are corporations, such as C corporations, that are required to file and pay income taxes on the income of the business. When the news is talking about the taxes that Amazon has to pay, Amazon as a corporation has to pay those taxes on it’s income.

The thing is, most small businesses are flow through entities. Approximately 95% of small businesses in the U.S. are flow through entities. This means that the business itself doesn’t pay actual income taxes. Instead, the income from the business flows through from the business to the owner(s) of the business and the owner(s) report the income on their personal tax returns and pay the tax due personally. LLC’s and S corporations are examples of flow through entities. Some flow through entities are subject to self-employment tax while others, like an S corporation or an LLC with an S election, does not pay SE tax. This is why it is very important to know the different types of structures when setting up your business.

Let’s look at a simple comparison. Bob and Sally are married and they own and operate a business together, B&S Wine Shop. B&S Wine Shop has net (taxable) income of $125,000 for 2023. That is total revenue minus total expenses. If B&S Wine Shop is a C corporation then B&S will pay a 21% corporate tax rate, or $26,250 in tax. That leaves B&S with $98,750 that it can declare as a dividend to Bob and Sally. That dividend will be taxed at 15% on their personal tax return, $14,813. Total tax paid $41,063 or 33% of the $125,000 income their business generated.

If B&S Wine Shop is an LLC and is subject to self-employment tax, then the full $125,000 would flow through to their personal tax return. B&S itself would not pay taxes. Bob and Sally would pay $17,662 in SE tax and then they would pay $16,172 in income tax (they get a deduction for half the SE tax paid). Total tax paid $33,834 or 27% of the $125,000 income their business generated. Plus, there would be additional tax savings if they made an S election for their business but we won’t cover that here.

Most small businesses choose a flow through entity because in the end it saves money in taxes. However, large businesses generally don’t meet the requirements to be a flow through entity so they are taxed at the corporate level instead.

There are a lot of arguments whether or not big corporations pay their “fair” share of taxes. Many people often argue that the corporate tax rate of 21% is too low. However, it is important to note that when the income after taxes is distributed as a dividend to the shareholders, it is taxed again. In the example above, B&S paid a 33% effective rate on their $125,000 income if taxed at the corporate level whereas only 27% as a flow through entity.

Information contained in this post is for educational purposes only and is not considered financial advice.