Flow-Through Tax vs. Entity Tax

Flow-Through Taxation

A flow-through entity is a legally designated entity type that allows business income to flow from the business to the business owners in the form of taxable income. The entity itself is not taxed and any business losses incurred or income earned is treated as the owner’s personal income/loss. The major types of flow-through business are:

  • Sole proprietor: an unincorporated business owned by a single individual
  • Partnership: an unincorporated business with multiple owners
  • Limited Liability Company (LLC): a type of business with limited liability like traditional c-corporation
  • S-corporation: a type of domestic corporation that can only be owned by U.S. citizens and cannot have more than 100 shareholders

A key benefit of flow-through tax status is that owners may deduct business losses against income from other sources. However, sole proprietors and owners of a partnership or S-corporation are also taxed a “self-employment tax”. In California, the average top marginal income tax rate on sole proprietorships and partnerships in the United States is 47%, and 44.5 and 48.3%, respectively, for active and passive shareholders of S corporations.

Entity Taxation

Unlike an LLC, corporations pay an entity level tax through the corporate tax code. Income passed to shareholders via dividends or stock repurchases are taxed on an individual level as income tax or capital gains tax. This tax sequence is commonly known as “double taxation.” The average entity tax rate, as a combination of federal and California state tax rates, is 31.9%. That rate, combined with individual income tax rates, makes the tax rate for c-corporation owners around 10% higher than owners of flow-through entities. Corporations may not use losses on their returns for the current year to reduce its current tax liability. However, corporations may carry losses on their returns for the current year backwards or forwards. In other words, a corporation can deduct against profits in previous or future years.

The Right Choice for Your Business

Since the Tax Reform of 1986, which substantially lowered individual income tax taxes, the number of flow-through tax entities has continuously increased. Between 1980 and 2011, the number of flow-through entities increased 175%. Of the 27.7 million firms in 2011, 94% were flow-through entities. Choosing the proper entity for your business can be tricky. Tax consequences are only one consideration. For example, many venture capitalists will only invest in your company if it is a corporation. Further, management structure of an LLC is far easier to change than the management of a corporation. If you have started or are thinking about starting a business, you should consult an experienced business and tax law attorney to help you talk through your options. Taxes, entity selection, and any unintended designations can lead to unexpected consequences. At the Royse Law Firm, we represent individuals located in the Los Angeles, Palo Alto, and San Francisco area. Contact us today to discuss how we can help your business.

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Roger Royse

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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