Flow Through Entity (Tax) - Explained
What is a Flow-Through Tax Entity?
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Table of ContentsWhat is a Flow-Through Entity?How Does a Flow-Through Tax Entity or Pass-through Entity Work? Types of Flow-Through EntitiesDownsides to Flow-Through EntitiesAcademic Research on Flow-Through Entity
What is a Flow-Through Entity?
A flow-through entity is a business entity is which income of the entity passes on to the investors or owners of the entity. In this legal entity, income flows through to the owners of the entity or investors as the case may be. Hence, the income of the entity is the same at the income of the owners or investors. That means the entity will not be taxed separately from the owners or investors. Once the investors are taxed, the entity is covered. A flow-through entity is the same is a pass-through entity. Many business owners and investors use it as a means of hedging double taxation. Here are some important things to note about flow-through entity;
- A legitimate business entity that passes income to owners or investors of the business is a flow-Through entity.
- A flow-through entity is also called a pass-through entity.
- Flow-through entities are different from C corporations, they are subjected to single taxation and not double taxation.
- The income of the business entity is the same as the income of the owners or investors.
- The income of the owners of flow-through entities are taxed using the ordinary income rate.
How Does a Flow-Through Tax Entity or Pass-through Entity Work?
There is no double taxation in a flow-through entity, no separate tax is levied on the income of the entity and the income of the owners. Rather than paying a separate tax on the business, investors pay tax on their income and this covers the business entity. Also, losses accrued by the entity can be used against the personal income of its owners. Flow-through entities are however not exempted from filing the K-1 statement with the Internal Revenue Service in the United States. Unlike C corporations that subjected to double taxation, flow-through entities are subjected to single taxation, owners of entities are not taxed separately from the entities.
Types of Flow-Through Entities
As identified by the Internal Revenue Service in the United States, flow-through entities are not taxed separately from their owners or investors. The reason for this is simple, there is an Income flow from the entity to its owners or investors, therefore, the income of the owner is also the income of the entity. In the U.S, there are three main categories of flow-through Entities are; S corporations, sole proprietorships and partnerships. Other categories of flow-through entities are limited liability companies and income trusts. In Canada however, investment corporations, whether mortgage, trust, mutual fund or partnership are regarded as flow-through entities.
Downsides to Flow-Through Entities
There is a criticism on the flow-through entity, this resulted from one of its drawbacks in which owners of entities are taxed on the income not directly receive by them but by the entity. This means that owners and investors of the business entity will be subjected to ordinary income tax based on the income of the business, even if the owners do not receive profits (dividends) from the entity.