# Understanding Flow-Through Entities: Types, Advantages & Disadvantages

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## What Is a Flow-Through Entity?

A flow-through entity is a legal business that passes any income it makes straight to its owners, shareholders, or investors. Only these individuals and not the entity itself are taxed on the revenues as a result. Flow-through entities help avoid [double taxation](https://www.investopedia.com/terms/d/double_taxation.asp), a common issue with income from regular corporations.

Flow-through entities are sometimes called disregarded entities because the IRS ignores them for tax purposes. Their owners, shareholders, and investors pay taxes on the income that flows or passes through to them instead.

### Key Takeaways

*   Flow-through entities pass income directly to owners, avoiding double taxation on corporate earnings.  
    
*   Common types include sole proprietorships, partnerships, LLCs, and S corporations.  
    
*   These entities pay no corporate tax; income is taxed at the owner's individual tax rate.  
    
*   Owners may owe taxes on undistributed profits, which can be reinvested into the business.  
    
*   Self-employment tax can apply to owners of some flow-through entities.

## Detailed Overview of Flow-Through Entities

Both businesses and individuals are taxable entities. They're liable to pay taxes on the money they earn.

Individuals pay [income tax](https://www.investopedia.com/terms/i/incometax.asp) on their wages and companies pay [corporate tax](https://www.investopedia.com/terms/c/corporatetax.asp) on their revenues but businesses that are set up as flow-throughs aren't subject to the corporate income tax. The income generated by a flow-through or a pass-through entity is instead treated solely as income of the investors, stockholders, or owners. Earnings directly pass or "flow through" to the individuals and so does the tax liability.

These individual stakeholders pay taxes on business income as though it is personal income and it's taxed at their ordinary income rate. The owners can also apply losses of the company against their personal income.

Flow-through businesses generally face the same tax rules as C corporations for inventory accounting, depreciation, and other provisions that affect the measurement of business profits but they're effectively taxed only once. Earnings generated by C corporations are [subject to double taxation](https://www.investopedia.com/terms/d/dividend-exclusion.asp). Income is taxed at the corporate rate first and it's then taxed again when it's paid out as dividends to shareholders or when shareholders realize capital gains from retained earnings.

## Common Forms of Flow-Through Entities

Flow-through entities are commonly grouped into sole proprietorships, [S corporations](https://www.investopedia.com/terms/s/subchapters.asp), income trusts, and limited liability companies. They can also be limited, general, and limited liability partnerships.

A sole proprietor reports all their business income on their personal income tax return. The IRS considers this form of company to be a flow-through given that the business isn't taxed separately.

S corporation profits flow through to shareholders who report the income on Schedule E of their personal tax returns. S corporation owners don't pay the Self-Employed Contributions Act (SECA) tax on their profits but they're required to pay themselves "reasonable compensation" which is subject to the regular Social Security tax.

A flow-through entity can be an investment corporation, a mortgage investment corporation, a mutual fund corporation, a partnership, or a [trust](https://www.investopedia.com/terms/t/trust.asp) in Canada.

> **Important**
>
> While flow-throughs are disregarded for tax purposes, partnerships and S corporations must still file an annual K-1 statement.

## Benefits of Choosing a Flow-Through Entity Structure

The greatest advantage of a flow-through or pass-through entity is tax treatment.

Incorporated businesses pay corporate income tax on profits before distributing them to shareholders, who then report dividends on personal tax returns, causing double taxation.

A flow-through entity allows profits to avoid the initial corporate tax round. A flow-through is exempt from business taxes. It passes earnings straight through to stakeholders who will owe taxes on that money but the money is taxed only once.

Some flow-through entities offer additional tax deductions for owners and investors. It also gets passed through if the business suffers a loss and can be used to reduce overall taxable income.

## Potential Drawbacks of Flow-Through Entities

A downside of flow-through entities is that owners are taxed on income even if they don't receive distributions. Investors must report their share of profits, and they may owe taxes even if profits are reinvested, not distributed.

Some pass-through entities' owners may also become subject to [self-employment tax](https://www.investopedia.com/terms/s/selfemploymenttax.asp) when they avoid corporate tax.

## Is a Flow-Through Entity the Same As a Pass-Through Entity?

Yes, a flow-through entity is the same as a pass-through entity.

## Does a Disregarded Entity Pay Taxes?

Yes, a disregarded entity pays taxes but it's often a single-person business or company so it's not treated or taxed separately from its owner by the IRS. It reports its income on the owner's personal tax return.

Disregarded entities pay two types of taxes, similar to [sole proprietorships](https://www.investopedia.com/terms/s/soleproprietorship.asp): a flat rate self-employment tax and an income tax that's assessed at a variable rate depending on the individual owner's tax bracket.

## Is a Single-Member LLC Automatically a Disregarded Entity?

A single-member [LLC](https://www.investopedia.com/terms/l/llc.asp) is automatically a disregarded entity but it can request to be taxed differently.

## Can a Disregarded Entity Have Employees?

Yes, a disregarded entity can have employees. The "disregarded entity" status is recognized only for purposes of federal income taxes. It doesn't affect employment and a disregarded entity with workers might have to pay employment taxes. 

The IRS and courts have ruled that a single-member LLC, one of the most common types of disregarded entities, cannot classify an owner as both an employee and a partner, however.

## The Bottom Line

Flow-through entities can save you from double taxation on a company's profits. Sole proprietorships, partnerships, LLCs, and S corps can take advantage of pass-through taxation but it's possible for owners of or investors in a pass-through entity to be taxed on income they didn't receive. This can happen if the income is put back into the business.

Some flow-through entities such as sole proprietors are also subject to self-employment tax so it's important to understand the [tax implications of your situation](https://www.investopedia.com/articles/personal-finance/120915/which-type-organization-best-your-business.asp).

> **Article Sources**
>
> 1.  Tax Policy Center. "[What are Flow-Through Enterprises and How Are They Taxed?](https://www.taxpolicycenter.org/sites/default/files/briefing-book/4.16.2-what_are_flow-through_entities_and_how_are_they_taxed.pdf)" Page 1.
>     
> 2.  Internal Revenue Service. "[Forming a Corporation](https://www.irs.gov/businesses/small-businesses-self-employed/forming-a-corporation)."
>     
> 3.  U.S. Small Business Administration. "[Choose a Business Structure](https://www.sba.gov/business-guide/launch-your-business/choose-business-structure)."
>     
> 4.  Internal Revenue Service. "[About Schedule E (Form 1040), Supplemental Income and Loss](https://www.irs.gov/forms-pubs/about-schedule-e-form-1040)."
>     
> 5.  Internal Revenue Service. "[S Corporation Compensation and Medical Insurance Issues](https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues)."
>     
> 6.  Government of Canada Revenue Agency. "[What Is a Flow-Through Entity?](https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/personal-income/line-127-capital-gains/flow-through-entities/what-a-flow-through-entity.html)"
>     
> 7.  Internal Revenue Service. "[Tax Information for Partnerships](https://www.irs.gov/businesses/partnerships)."
>     
> 8.  Internal Revenue Service. "[S Corporations](https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations)."
>     
> 9.  Internal Revenue Service. "[Topic No. 404, Dividends](https://www.irs.gov/taxtopics/tc404)."
>     
> 10.  Internal Revenue Service. "[Sole Proprietorships](https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships)."
>      
> 11.  Internal Revenue Service. "[Single Member Limited Liability Companies](https://www.irs.gov/businesses/small-businesses-self-employed/single-member-limited-liability-companies)."
>      
> 12.  Internal Revenue Service. "[Limited Liability Company (LLC)](https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc)."