What Is a Flow-Through Entity? Are There Disadvantages to This Business Type?

What Is a Flow-Through Entity? Are There Disadvantages to This Business Type?

August 5, 2020

A flow-through entity, also known as a “pass-through” entity, is a legal business entity that doesn’t pay taxes of its own. Instead, any profits, loss and other business finances are passed on to each owner, who reports it on their personal income taxes. When your business operates as a flow-through entity, it’s important to use a professional tax preparation service in Hayward, CA. Relying on an expert will ensure that these important taxes are not only done properly, but will help you get the biggest credits and deductions available.

How a flow-through entity works

Flow-through entities are business entities like sole proprietorships, partnerships, LLCs and S-corporations. (In fact, the only type of business entity that isn’t a flow-through entity is a C-corporation.) The idea behind them is to avoid double taxation—that is, getting taxed on your business income as well as the personal income that it generates for you.

If there’s only one owner, the profits and losses “flow through” directly to your personal income tax. The same goes if you have more than one owner—the money flows through according to your business agreement, and the company will not have to pay a corporate tax.

Bear in mind that owners of flow-through entities still have to pay state and local income taxes, unless they live in a state without personal income tax. They may also have to file a tax return for the business with the federal and state governments, but they will not need to pay additional taxes on behalf of the business.

Additionally, S-corporation stakeholders will need to report their stock income on their personal income tax, under Schedule E. They should make sure to discuss this with their professional tax preparation service in San Leandro, CA.

Advantages and disadvantages of flow-through entities

Obviously, the major advantage of a flow-through entity is that you won’t get taxed twice, unlike C-corporations. C-corporations have to pay corporate tax, and the owners and stakeholders must pay personal income tax on their share of the income.

When a C-corporation takes profits and reinvests them in the business, that’s called retained earnings—and C-corporation shareholders don’t have to pay taxes on them. Unfortunately, that’s not the case with S-corporations and other flow-through entities. Owners of flow-through entities have to pay taxes on all of the business’s profits, whether they were reinvested or not.

This structure can make it more difficult for flow-through entity owners to reinvest money in their business—after all, if they have to pay personal income tax on that money, wouldn’t it be smarter to keep it? That can be a struggle for many flow-through businesses.

Finally, it’s much harder to deduct charitable contributions if you’re a flow-through entity. C-corporations can deduct up to 10 percent of the company’s total income as a business expense. If your company is considering a lot of charitable giving, you might be better off filing as a C-corporation.

For professional tax preparation services in the Castro Valley area, Menjivar & Company CPAs, Inc. is ready to help. Reach out to us to schedule a consultation.

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