Business Taxation: What are flow-through enterprises and how are they taxed?
Many businesses are taxed as flow-through enterprises, which are not subject to the corporate income tax as are corporations taxed under subchapter C of the Internal Revenue Code (C corporations). Instead their shareholders or partners include their allocated share of profits in taxable income under the individual income tax. These include corporations organized under subchapter S of the Internal Revenue Code (S corporations), partnerships, and sole proprietorships.
- Domestic companies with no more than 100 shareholders may elect S corporation status. Shareholders must be U.S. citizens or residents and generally may not be corporations or partnerships. In addition, S corporations may have only one class of stock.
- Partnerships have always been taxed as flow-through enterprises, but in the past they were not afforded the benefits of limited liability that the corporate form provides. State laws allowed partnerships to organize themselves as limited-liability companies beginning in the late 1970s, and "check the box" regulations instituted by the Treasury Department in the 1990s made it easy for any business to elect limited liability status.
- C corporations and flow-through businesses generally have the same rules for inventory accounting, depreciation, and other provisions affecting the measurement of business profits. But profits of C corporations are first subject to the corporate income tax (at rates up to 35 percent) and then taxed again when paid out as dividends to shareholders or when shareholders realize capital gains arising from retained earnings. (The maximum tax rate on dividends and capital gains is 15 percent through the end of 2010.) In contrast, profits of flow-through businesses are taxed just once, at the shareholder’s individual tax rate for ordinary income, for which the top rate is currently 35 percent.
- Another benefit of flow-through status is that individuals may deduct business losses against income from other sources, subject to some limitations for "passive losses" from partnership income. In contrast, corporations may not use losses on their return for the current tax year to reduce current-year tax liability; instead losses may be carried back (up to two years) or carried forward (up to twenty years) and deducted against profits in previous or future years. To the extent corporations are unable to claim loss carrybacks, the tax offsets from these losses are delayed and reduced in present value.
- The share of businesses organized as flow-through businesses and the share of business receipts in flow-through enterprises have been rising over time (see figure). Excluding sole proprietorships, 75 percent of businesses were organized as flow-through enterprises in 2004, up from 60 percent in 1994; during that same period flow-through enterprises increased their share of business receipts from 23 percent to 33 percent. Most large businesses, however, are still corporate taxpayers. In 2004, S corporations accounted for 64 percent of all corporations with assets less than $10 million and received 56 percent of gross business revenues of those companies, but for only 37 percent of corporations with assets greater than $10 million and only 12 percent of business receipts in that category.