Flow Through Taxation
Limited liability companies, partnerships, and subchapter S corporations have so-called “flow through taxation.” That means that the entity files a tax return but the taxes are owed by the shareholders. Typically the taxes are assessed based on a percentage of ownership. Flow through losses may be beneficial if you have other income which you can shelter with the losses. Flow through profits are good if you get a distribution. There is no requirement for flow through entities to make distributions so you could end up with taxable income, tax liability, and no money to pay the taxes. Some flow through entities provide limited liability (LLCs, LPs, Sub S Corps) and some do not (general partnerships). They are great for businesses being run for cash flow with many non-employee shareholders, since dividends are not doubly taxed. If all owners are employees erstwhile profits can be distributed as paychecks and bonuses which are chargeable at the corporate level. But if many owners are not employees dividends are the only way to distribute profit. Typically the entity keeps a capital account for each owner. Investments and undistributed profits increase an owner’s capital account, while distributions and distributed losses decrease an owner’s capital account. But be careful of a negative capital account because having that written off can result in discharge of indebtedness income. Some flow through entities are allowed entity owners and some are not. LLCs are sometimes used for strategic alliances because each alliance partner receives a cash flow stream to use as it pleases. If a new business is set up for cash flow, a flow through entity makes sense; if it is set up for capital appreciation maybe a non-S corporation makes more sense. Flow through entities can convert into non flow through entities, but it is harder to convert the other direction. If you are considering a new entity, talk to your accountant about whether a flow through entity makes sense for you.
-- Paul Marotta