The federal corporate income tax rate in the United States is 21%. But 44 out of 50 states also tax corporations on their income.
State corporate income tax rates range from 3% in North Carolina to 12% in Iowa. Although, most state tax rates are around 6%. And in some cases, the owners and shareholders of C-corporations are subject to double taxation.
Avoiding double taxation is the reason why some corporations are choosing to become flow-through entities.
If you’re wondering what a flow-through entity is and how it’s taxed, keep reading. We’re sharing with you everything you need to know.
What Pass-Through Taxation Is
Flow-through entities, also known as pass-through entities are business entities that pass their income to the owners and/or investors of the company. When the income is passed straight through to owners and/or investors, it limits taxation by avoiding double taxation.
Instead, only investors and/or owners are taxed on revenues rather than the business itself.
What Double Taxation Is
Double taxation occurs with C-corporations. It happens when a corporation pays taxes on its revenue but then the owners and shareholders are taxed on the income they earned from the dividends they receive from the corporation.
Only C and S corporations can pay out dividends. Partnerships and LLCs (limited liability companies) can not pay out dividends. Dividends are different than cash distributions and they’re only paid out once.
To avoid double taxation, most businesses choose to form a different business structure such as an S-corporation or LLC.
How Pass-Through Taxation Works
Rather than the business itself being taxed, the business revenue is taxed on the business owner’s tax returns as individual income tax. Since business owners and shareholders can avoid double taxation, the number of C-corporations has declined while the number of pass-through businesses has nearly tripled since 1980.
In the 1980s C-corporations were producing nearly all the business income. But by 2014, only 44% of income earned by business owners came from a C-corporation.
Most Companies are Small Businesses
While it may seem as though flow-through businesses are smaller than C-corporations, they’re not all small businesses. However, 99% of all businesses in the United States are small businesses with $10 million in sales or less.
In 2014, 95% of businesses were pass-throughs. Only 5% of businesses were classified as C-corporations.
Pass-Throughs Can Apply Losses Against Personal Income
Another reason why pass-through entities are so popular as a business structure is that the owners can apply any losses of the company against their own personal income.
Also, thanks to the Tax Cuts and Jobs Act, owners of pass-through entities can deduct up to 20% of their qualified business income. While this new rule doesn’t apply to every business entity, if a business owner has a taxable income under $157,500 (if single) or $315,00 (if married and filing jointly).
8 Types of Flow-Through Entities
Companies have several choices as to the type of business structure they want to form.
1. Sole Proprietorships
Sole proprietorships are businesses with a single owner. These types of businesses do not need to file a separate return. Instead, the owner reports his or her net income on Schedule C on their individual tax return.
Generally speaking, all net income from a sole proprietorship is subject to payroll taxes. Common examples of Sole Proprietorships could be:
- Fitness Coaches
A partnership is usually formed by two business owners.
They file an entity-level tax return (Form 1065) but the profits are allocated to owners reporting their share of the net income of the business on Schedule E on their individual tax returns.
An LLC can be formed by one or more individuals. This type of business structure shares similarities to both sole proprietorships and corporations.
The owners of LLCs can choose to be taxed as a partnership. If they do, all general partners are subject to SECA (Self-Employment Contributions Act) tax on their net income.
However, in a limited partnership, owners are only subject to SECA tax on guaranteed payments representing compensation for labor services.
Domestic corporations that meet the criteria for an S-corporation file a corporate tax return (Form 1120S). However, its profits flow through to its shareholders and any income is reported on Schedule E of the shareholder’s personal income tax.
To form an S-corporation a business must:
- Not have more than 100 shareholders
- All shareholders must be U.S. citizens or resident individuals
- May issue only one class of stock
Unlike partnerships and LLCs, S-corporations do not have to pay SECA tax on profits. They do, however, have to pay themselves reasonable compensation which is then subject to Social Security tax.
5. Foreign Partnerships
A foreign partnership refers to any partnership not organized under the laws of any U.S. state, within Washington, D.C. or is a partnership treated as foreign under income tax regulations.
If that foreign partnership isn’t a withholding partnership, those individuals receiving income are considered the partner of the partnership as long as those partners are not themselves a flow-through entity or foreign intermediary.
6. Foreign Simple Trusts
A trust is considered foreign unless it can meet the following criteria:
- A U.S. court can exercise primary supervision over the administration of that trust
- One or more U.S. citizens possess the authority to control all major decisions of that trust
A foreign simple trust is a foreign trust that’s required to distribute all of its income on an annual basis.
7. Foreign Grantor Trusts
A foreign grantor trust is also a foreign trust and it’s treated as a grantor trust under sections 671 through 679 of the Internal Revenue Code.
With a foreign simple trust, the payees of a payment are the beneficiaries. With a foreign grantor trust, the payees of a payment are the owners of the trust.
8. Fiscally Transparent
You can treat a business as a flow-through entity if the reduced rate of withholding under an income tax treaty is claimed.
It’s determined based on income basis along with applying the laws of the jurisdiction where the interest holder is a resident, organized or incorporated.
4 Pass-Through Entity Benefits
There are other reasons to want to structure your business as a pass-through entity besides avoiding double taxation.
1. More Net Income
Flow-through businesses earn more net income than C-corporations.
2. Favorable Tax Rates
Since the revenue is taxed an individual income, there’s only one layer of tax. The tax rates are lower than with C-corporations.
3. More Popular
Most companies choose flow-through entities due to the myriad financial benefits. C-corporations have been steadily declining since the 1980s.
4. No Restrictions on Size
While most businesses in the United States are small businesses, not all flow-through entities are small. Pass-through entities range from single individuals to companies with a thousand employees.
There are no size limits with flow-through entities.
Pass-Through Entity Downsides
It’s possible for the owners of a company to be taxed on income they don’t directly receive. Even if the business doesn’t distribute profits in the form of dividends, the company’s owners and shareholders will still be taxed on the business’s revenue.
Also, with an S-corporation, any remaining profits after taxes can either be distributed as a dividend or reinvested in the business.
Shareholders of C-corporations don’t have to pay any taxes on those retained earnings. Those with S-corporations or LLCs do, even if they are retained, making it difficult to save money to grow their business.
Higher Individual Tax Rates for Pass-Through Entities
Also, most of the income earned from pass-through businesses are taxed at the highest individual tax rates.
In some states, those marginal tax rates can be higher than 50%.
C-corporations Can Deducte Fringe Benefits
C-corporations can also deduct fringe benefits from their taxable income. Fringe benefits include:
- Health insurance
- Paid time off
- Commuter benefit
Flow-through entities do have to pay taxes on the value of any fringe benefits they receive.
How to Create a Pass-Through Entity
Even flow-through entities must adhere to the same tax rules as a C-corporation in regards to profits. To determine taxable income, you must deduct your business losses from your current income.
Note: State income tax return rules vary by state, but the rules for federal income taxes are uniform.
Federal Income Tax
If you’re a sole proprietorship or a one-member LLC, you must include all your business profits and losses in a schedule C and file it with your individual income tax.
LLCs and Partnerships
For multi-member LLCs and partnerships, individuals must pay taxes on their own share of profits and losses. Your operating agreement should describe each member’s shares.
Any profits and losses are filed using Schedule E.
Subject to Self-Employment Tax
Members of an LLC must pay taxes on their whole distribution. Even if it’s not distributed every year. And you may also be subject to self-employment tax since LLC members are not considered employees.
Members who are investors do not have to pay this tax. But owners working or managing the business must pay self-employment taxes based on their distributed shares.
Can Reduce Taxes With Deductions
However, a lot of the business income can be written off by deducting business expenses such as:
- Start-up costs
- Travel expenses
- Office supplies
Speak to a qualified business tax attorney to see which deductions you can legally take to lower your income tax.
State Income Tax
While tax rules and regulations vary between each state, most states treat profits generated by LLCs the same way as the IRS (Internal Revenue Service). Instead of the LLC paying state taxes, the owners pay state taxes on their personal returns.
If that income reaches a certain amount, you may be subject to a tax.
State Income Tax Rules in Maryland
If your flow-through business falls under Maryland state income tax laws, you must file Form 510 even if the business is inactive or generated $0 in income.
If the flow-through entity operates in Maryland but isn’t subject to its income tax law, the business can file a return that reflects no income owed to the state. You must file a return as letters stating this information isn’t accepted.
Subsidiaries, Single-Member LLCs, and Inactive Partnerships in MD
If you own a Qualified Sub-S Subsidiary which isn’t considered a separate entity in Maryland, the subsidiary must be included in the parent company’s annual Maryland return.
If you own an LLC as a single member and you wish to be disregarded as a separate entity or you have an inactive partnership that elects not to be treated as a partnership in Maryland, the state of Maryland will follow IRS rules.
Flow-Through Entity Tax Reform
The Tax Cuts and Jobs Act which passed at the end of 2017, enacted new tax reforms that affect flow-through entities. As an owner of a pass-through entity, you can now claim a 20% tax deduction of your share of business income before you pay federal income taxes.
In other words, if you’re a sole proprietor earning $100,000 in business income, you can now deduct $20,000 of your taxable income. You’re then only required to pay taxes on the remaining $80,000.
Rules of Eligibility for Taking Tax Deductions
Of course, there are many rules regarding eligibility to receive a flow-through deduction. You can only take advantage of your total taxable income is below a certain limit. That limit is adjusted annually for inflation.
In 2019, the limit was $321,400 for married, jointly filing taxpayers. If you were a single taxpayer, the limit was $160,700.
What Happens if You Exceed the Eligibility Rules for Tax Deductions
However, for those whose taxable income exceeded those limits, the deduction was phased out. But only based on the number of wages you paid, along with the property your company owns.
If you were at a higher level, the maximum deduction was still 20%. But, any deductions you take is limited, based on the greater of:
- 50% of any wages you paid to your W-2 employees: or
- 25% of the W-2 wages, plus 2.5% of the acquisitions costs of any depreciable business properties
For those companies without employees or who don’t own any business properties, if you’re past the income limit, you can’t take any deductions at all. This was done to incentivize business owners to hire employees and invest in property.
Certain Service Providers aren’t Eligible for Tax Deductions Due to High-Income Levels
However, there are certain types of service providers. Examples such as lawyers, doctors, and consultants who couldn’t claim any deductions in 2019 if their income topped $421,400 for married and joint filers. And $210,700 for single filers.
Consult With the Professionals
Deciding whether to create a pass-through entity or a C-corporation is a complicated matter. There are a lot of aspects to consider to determine what makes the most fiscal sense.
That’s why it’s so important to work with the right tax professionals. We’re here to help you make smart business decisions. Click here to schedule a consultation with us.