What Is a Flow-Through Entity for Tax Purposes?

A flow-through entity is a business structure where income and losses are passed directly to the owners’ personal tax returns, avoiding entity-level taxation. This contrasts with traditional corporations that pay corporate income tax. Businesses choose this structure to simplify their tax obligations and potentially reduce their overall tax burden.

Understanding the Flow-Through Concept

A flow-through entity, also known as a pass-through entity, does not pay federal income tax at the business level. Its profits and losses are reported directly on the owners’ individual tax returns, where they are treated as personal income.

This structure allows businesses to avoid “double taxation,” a common issue with C corporations. In a traditional corporate setup, income is taxed first at the corporate level and then again when distributed to shareholders as dividends. With a flow-through entity, income is taxed only once, at the owner’s individual income tax rate.

The direct impact on owners’ taxable income occurs whether or not they receive actual cash distributions from the business. If the business earns a profit, each owner’s share of that profit is added to their personal taxable income. Conversely, if the business incurs a loss, owners can often use their share of these losses to reduce their overall taxable income from other sources.

Common Flow-Through Entity Structures

Several common business structures operate as flow-through entities for tax purposes. Each type offers distinct characteristics while sharing the fundamental principle of passing income and losses directly to owners. This approach simplifies the tax landscape for many small to medium-sized businesses.

A sole proprietorship is an unincorporated business owned and operated by a single individual. For tax purposes, there is no legal distinction between the owner and the business, meaning all business income and expenses are reported on the owner’s personal tax return. This makes it the simplest form of flow-through entity.

A partnership is a business owned by two or more individuals or entities, where profits and losses are allocated among the partners according to their partnership agreement. Partnerships file an informational return with the IRS, but the tax liability flows through to the individual partners. Each partner then reports their share of income or loss on their personal tax return.

An S corporation is a corporation that elects a special tax status with the IRS to pass corporate income, losses, deductions, and credits directly to its shareholders. This election allows the S corporation to retain some of the legal protections of a traditional corporation. Shareholders report their share of these items on their individual tax returns.

A Limited Liability Company (LLC) is a hybrid business structure that offers owners liability protection similar to a corporation. For tax purposes, an LLC is highly flexible and can be taxed as a sole proprietorship (if it has one owner), a partnership (if it has multiple owners), or it can elect to be taxed as an S corporation or even a C corporation. By default, most LLCs are treated as pass-through entities, with income and losses flowing through to the members’ personal tax returns.

Taxation of Flow-Through Entities

The taxation of flow-through entities involves specific reporting mechanisms that ensure income and losses are appropriately attributed to owners. These entities must file an informational return with the IRS. For example, partnerships file Form 1065, and S corporations file Form 1120-S.

A crucial document in this process is Schedule K-1. The business issues a Schedule K-1 to each owner, which details their share of the entity’s income, deductions, credits, and other financial items. Owners then use this information to complete their personal tax return, ensuring their portion of the business’s profits or losses is included in their individual taxable income.

Owners of flow-through entities pay income tax on their allocated share of the business’s profits at their individual tax rates. It is important for owners to consider this when managing business finances.

The concept of “owner’s basis” in the entity is important for deductibility of losses and tax treatment of distributions. An owner’s basis generally represents their investment in the business, adjusted for income, losses, and distributions. Losses passed through to an owner can only be deducted up to the amount of their basis.

Self-employment tax applies to the net earnings from self-employment for sole proprietors and partners. This tax covers Social Security and Medicare contributions. For S corporation shareholders, only the reasonable compensation they receive as wages is subject to payroll taxes, not the entire distribution of profits. The self-employment tax rate is generally 15.3%, comprising 12.4% for Social Security and 2.9% for Medicare.

Owners of pass-through entities may be eligible for the Qualified Business Income (QBI) deduction. This deduction allows eligible taxpayers to deduct up to 20% of their qualified business income. This deduction applies through December 31, 2025, and aims to provide a tax benefit comparable to the corporate tax rate reduction.