User:Spamidi/Flow-through entity

Flow-Through Entity
A flow-through entity (FTE) is a legal entity where income "flows through" to investors or owners; that is, the income, loss, deductions and credits of the entity "flow-through" and are treated as the income of the investors or owners, and taxed at that level. Flow-through entities are also known as pass-through entities or fiscally-transparent entities. Flow-through entities are commonly opted by business owners to avoid double-taxation.

Common types of FTEs are sole proprietorships, general partnerships, limited partnerships and limited liability partnerships. In the United States, additional types of FTE include S corporations, income trusts, estates and limited liability companies.

Most countries require an FTE (or its owners) to file an annual return reporting the shares of income allocated to owners, and to provide each owner with a statement of allocated income to enable owners to report their shares of income on their own tax returns. In the United States, the statement of allocated income is known as form K-1 (or Schedule K-1).

Depending on the local tax regulations, this structure can avoid dividend tax and double taxation because only owners or investors are taxed on the revenue. Technically, for tax purposes, flow-through entities are considered "non-entities" because they are not taxed; rather, taxation "flows-through" to another tax return.

Other Definitions and Interpretations
According to International Bureau of Fiscal Documentation (IBFD) a pass-through entity or flow-through entity (FTE) is a "non-taxable entity, such as a partnership, under which the income or expense is generally regarded as income or expense of the participants under the transparency principle." FTEs are based on conduit theory or pipeline theory which is defined as a "method of integrating the taxation at the entity and participator level under which income or deductions flow through from the entity to its participators. The entity is in effect regarded as an extension of the participators. A partnership is generally taxed according to the conduit system. The conduit system may be contrasted with the classical system."

United States
In United States pass-through entities include "sole proprietorships, partnerships and S corporations that pay taxes at the individual rate of their owners" as well as income trusts and limited liability companies.

According to CNN Money, in the United States, most "businesses are set up as pass-throughs, not corporations" which "means their profits are passed through to the owners, shareholders and partners, who pay tax on them on their personal returns under ordinary income tax rates." In other words pass-through businesses are not "taxed like corporations and instead pay taxes on business income as if it were personal income."

Sole proprietorships
A sole proprietor is "someone who owns an unincorporated business by himself or herself.". In the United States, sole proprietors "must report all business income or losses on [their] personal income tax return; the business itself is not taxed separately. The IRS refers to this as "pass-through" taxation, because business income and expenses pass through and are reflected on the "Schedule C, Profit or Loss From Business" as part of their 1040, U.S Individual Income Tax Return form . While the business income, losses and distributions are pass-through, sole proprietorships are still liable for self-employment taxes at 15.3% and are required to file the Schedule SE, Self Employment Tax, this is only applicable if the net earnings, per the filer's Schedule C are $400 or more . Owners can deduct their employer equivalent portion which decreases their income tax; and as per the Section 2042 of the Small Business Job act, are allowed to deduct the individual's cost of health insurance.

Partnerships
A (general) partnership is an unincorporated entity with more than two or more individuals who are engaged in trade and/or individuals, and where each members contributes capital, labor, skills or have a share in the business. A partnership is required to file information return about their income, gain, losses, deductions and credits on Form 1065, U.S. Return Of Partnership Income, however, a partnership doesn't pay tax on its income rather it passes on to the personal income tax return, filed under Form 1040, U.S Individual Tax Return. Shareholder-partners who are employed in the corporation are required to pay self-employment taxes, as part of Schedule SE (Form 1040), Self-Employment Tax. The SE payroll tax is charged at 15.3%, and there are additional state and local income tax rates.

Limited Partnerships (LP)
A Limited partnership is an iteration of a partnership that has 2 or more partners, and there is at least one limited or passive partner who does not actively participate actively in day-to-day business operations. The IRS doesn't distinguish between LP and general partnerships, so LPs are taxed as pass-through entities and partners will have to follow the same procedure stated above. Moreover, passive partners are not required to pay any self-employment tax, unlike general or active partners (in this a LP) who are required to do so.

Limited Liability Partnerships (LLPs)
A Limited Liability Partnership is a type of business entity that offers limited liability to its partners. Each partner's liabilities are limited by the amount of money they put into the business. Like a LLC, a LLP is subject to state rules for incorporation, however, LLPs have an addition layer where states reserve the right to incorporate this form of an entity to certain trades - accounting, law firms and real estate being the most common. LLPs do qualify for pass through-taxation, but can not choose to be incorporated as a corporation.

Distributions and Self-Employment Taxation
Distributions are made to partners of the entity as per their partnership operating agreement. These distributions are made in the form of cash payments and can be issued in a periodical. Unlike S-corps, these distributions don't qualify for special tax treatment and add-on to the 1040 form, Schedule E.

Additionally, distributions and self-employment taxation can vary through "Active" and Passive income. General/Active partners who are involved in the business are required to pay self-employment taxes for the income received for their shares of partnership, whereas, passive partners do not. Limited Partners (who are a part of Limited Liability Partnerships or Limited Partnerships) are subject to self-employment taxes on guaranteed payments for the services they provide. Limitations do apply for "limited partners" if they are working in a service sector entity such as law firm, medical practitioners and more.

Limited Liability Companies (LLCs)
A Limited Liability Company is an entity that is created by following the state statutes. An LLC consisting of two or more members will be taxed as a partnership by default, however, members can choose to file as a C-corporation (where "pass-through" status is lost) or a S-corp) by filing Form 8832. When LLCs opt to be taxed as a S-corp or Partnership, then they follow the guidelines stated in the respective sections.

Disregarded Entities
A disregarded entity or also known as a Single-Member LLC, is an entity which (1) has a single owner, (2) has not elected to be treated as a corporation and (3) has not elected to be recognised as a separate entity for federal tax-purposes. The additional benefit with the disregarded entities is the limited liability protection, in comparison to sole proprietorships is that these entities also qualify for pass-through status. The tax procedure is the same sole proprietorships, the owner has to file the 1040, US Individual Income Tax Return form . Owners who want to incorporate their entity as a Single-Member LLC by filing Form 8832,, along with any additional forms which need to be filed, per state rules.

By default, a single-member LLC is considered a disregarded entity, where the member is a separate entity from the business, unless, the member file Form 8832 to be filed as a corporation

S corporation
S corporations (S-corp) are entities that have similar legal protection of a C-corporation, but have an additional benefit to elect to pass-through profits, losses, deductions and credits to their shareholders, who will report those earnings or losses on their personal income tax returns on the Schedule K-1 (Form 1065). S-corps enjoyer a higher level of "pass-through" treatment in comparison to other pass through entities (like Sole proprietorships, partnerships and LLC taxed in any other form than a S-corps) in the form an exemption for self-employment taxes and distributions, instead of dividends. The below benefits are only applicable to entities which file for incorporation as an S-corp or are LLC which choose to be taxed as S-corps, visit the S-corporation article to see eligibilities and incorporation.

Self-Employment Tax
An additional benefit to avoiding federal taxation at the entity level, is that owners of the S-corp who work as employees within the S-corp can lower their burden of their self-employment taxes - when an owner receives a salary payment for their services to the S-corp as an employee, the payment is deductible to the business and taxable on their personal taxation level, which ensures that the employee when they receive a salary are not subject to self employment taxes and income taxes (unlike sole proprietorships and partnerships), instead just an income tax. However an S-corp is required to pay FICA/payroll taxes for all their employees.

Additionally, to ensure this non-self employment taxation benefit, S-corps are required by IRS Form 1120S, U.S Income Tax Return for an S Corporation, to meet the "reasonable compensation" standard, along with the the corporation's income, deductions and credits. According to IRS, distributions or any other payment to any shareholder-employee by the business can be treated as a salary deductible by the business and taxed on the personal income level as long as they are "reasonable" for the services the person has rendered to the corporation. While there are no certain set factors determining the "reasonable standard", the courts have used the following standards and characteristics -


 * 1) Training and experience
 * 2) Duties and responsibilities
 * 3) Time and effort devoted to the business
 * 4) Dividend history
 * 5) Payment to non-shareholder employees
 * 6) Timing and manner of paying bonuses to key people
 * 7) Compensation agreements
 * 8) What comparable business pays for similar services

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Distributions ===== An additional way S-corp shareholders enjoy pass-through treatment is when they receive tax-free distributions instead of dividends. Traditionally dividends given in other pass-through entity types which don't elect an S-corp status are subject to taxes before the shareholders receive them, however, an S-corp can proceed to hand out tax-free distributions unless as long as the shareholders hold an adequate stock basis and the distributions don't exceed the shareholder's stock basis. If the distributions do exceed the stock basis, then the additional value shall be reflected as a capital gain (even if it's held for over a year as a long-term capital gain), which will be taxed. It is important to note that distributions can only be handed to shareholder-employees after they receive a "reasonable compensation" as described above. S-corps will face a higher amount of scrutiny, if they can not show there's a reasonable divide between distributions and salaries paid to their shareholder employees. Predominantly relying on distributions as a form of compensation and to avoid FICA/payroll taxes can lead to legal liability and loss of S-corp status.

Bond and bond option sales strategy (BOSS)
FTEs included in the 2009 IBFD International Tax Glossary included the Bond and Bond Option Sales Strategy (BOSS) transaction] referring to an "investment strategy developed in the United States to generate tax losses without a corresponding economic loss. The transaction involves the use of a partnership or other flow-through entity that makes an investment in a foreign corporation that is capitalised for the purpose of carrying out the transaction. Variants of Boss Transactions are referred to as Son of Boss Transactions.

Canada
==== List of Entities ==== In Canada, an individual will be eligible to be considered as a member of flow through entity and be eligible to report their income and/or withhold any deductions, l if they are a member/investor or have an interest in the following entities listed below -


 * 1)  An investment corporation
 * 2) A mortgage investment corporation
 * 3) A mutual fund corporation
 * 4) A mutual fund trust/corporation or a related segregated trust
 * 5) A general partnerships, limited partnerships, limited liability partnerships and sole proprietorships
 * 6) A trust
 * 7) Governed by an employee's profit sharing plan
 * 8) Established to secure debt obligations for creditors
 * 9) Hold a corporation's voting right attached capital stock
 * 10) Maintained primarily to hold interest in shares of the capital stock of an organisation or two or more organisations which are not dealing at "arms-length" with each other.

Sole Proprietorships
A sole proprietorship is an unincorporated business owned by one individual. Since a sole proprietorship is recongnised as a "pass-through entity", Income/losses should be mentioned on the personal T1, Income Tax and Benefit Return. Most entities (except for those in Agricultral and Fishing industries) will have to file an addendum form T2125, Statement of Business or Professional Activities while filing their person T1 income tax form. If you have more than entity, then you are required to file one form per each entity

Ownership of interest or Shares In a United States LLC
Canadian residents who an interest or share in a flow-through entity in the USA should only consider direct ownership when they become non-residents of Canada. The revenue agency does not require the "pass-through" status of the qualified entities in the USA, and members will face additional tax charges when they receive dividends (a taxed distribution) and/or salary payments.

Disposing Shares or interest In A Flow-Through Entity
According to the Canadian revenue agency, when a person disposes their shares or interest in a flow-through entity, they should calculate the difference in between the proceeds of the disposition minus the adjusted cost base (ACB) and other expenses. These dispositions should be mentioned out on the Schedule 3, Capital Gains or Losses.

The Tax Cut and Jobs Act of 2017
Main article: Tax Cut and Jobs Act of 2017

On December 2, 2017 the U.S. Senate passed a tax overhaul bill as part of the proposed Tax Cuts and Jobs Act of 2017 (TCJA) that reduced taxes on pass-through business income by allowing them to "deduct 20% of their income". The Senate added features to the bill to prevent abuse. In a November article, The New York Times reported that the tax bill would "[r]educe the pass-through tax rate to 25% regardless of income level. Since 95% of businesses are incorporated as pass-through entities Examples include "sole proprietorships, partnerships and S corporations that currently pay taxes at the individual rate of their owners." whose owners pay taxes as if it were personal income at a much lower rate. This represents a large tax cut for owners that is capital as opposed to labor. Approximately the largest 2% of pass-through businesses represent 40% of pass-through income and today are taxed at 39.6%, the top individual rate."

According to the IRS, The aspect of the TCJA which created a valuable deduction for small business owners was the Qualified Business Income (QBI) deduction. Income from all of the pass through entities in the United States (stated above), including some trusts and estates may qualify for a QBI deduction, also known as section 199A, which has become available after 31st December 2017. The deductions are available on Schedule A Eligible taxpayers can deduct upto 20% of their QBI. The deduction is susceptible to limitations based on - taxpayer's deductible income, the type of trade or business, amount of W-2 wages paid by the qualified business and any unadjusted basis of an acquisition of qualified property held by the trade or business. QBI also extends to the deductible part of self-employment tax, self-employed health insurance and contributions for qualified retirement plans.

However, QBI doesn't apply for following items -


 * 1) Items that are includable in taxable income
 * 2) Capital gains, losses or dividends
 * 3) Wage income
 * 4) Income not effectively connected with the conduct of business within the United States
 * 5) Amounts received as a reasonable compensation from an S corporation
 * 6) Amounts received as guaranteed payments from a partnership
 * 7) Payments received by a partner for services which are different from the capacity of a partner
 * 8) More found here.

Though C-corporation don't qualify for a QBI deduction, the TCJA lowered the corporate tax rate from 35% to 21%, permanently.

Chronology
According to a report published by Brookings in May 2017, in the early 1980s almost all business income in the United States was generated by C corporations. In terms of Income tax in the United States C corporations are taxed separately from their owners.

In December 2004 the Financial Asset Securitization Investment (FASIT) which was a flow-through entity formed in the United States, was repealed. FASIT was an investment instrument in "non-mortgage receivable pools such as credit card receivables, automobile loans, construction loans, and finance leases." FASITS in existence on October 24, 2004 were exempted from the repeal.

By 2005 the US Internal Revenue Service viewed Son of Boss as "an abusive transaction aggressively marketed in the late 1990s and 2000 primarily to wealthy individuals." The IRS began a "settlement initiative" which "required taxpayers to concede 100 percent of the claimed tax losses and pay a penalty of either 10 percent or 20 percent unless they previously disclosed the transactions to the IRS."

By 2013, "only 44 percent of the income of business owners was earned through C-corporations."

Starting in 2013, Kansas Governor Sam Brownback undertook what was described by The Atlantic in a June 2017 article as the United States' "most aggressive experiment in conservative economic policy". From 2013 to 2017, 300,000 businesses as pass-through income entities, benefited from the complete tax exemption. [T]ens of thousands of Kansans were able to "claim their wages and salaries as income from a business rather than from employment." Brownback's tax overhaul created pass-through income tax exemptions as well as trimming income tax, eliminating some corporate taxes. From 2013 to 2017, Kansas experienced budget shortfalls culminating in a $350 million budget shortfall in February 2017, which "threatened the viability of [the state's] schools and infrastructure". In response, in June 2017, the extreme tax cuts were rolled back to 2013 levels.

By 2017, pass-through businesses earned the "majority of business income" in the United States and "owners of S-corporations and partnerships now earn about half of all income from businesses."

According to a September 2017 article in The New York Times, about "95 percent of companies in the United States are structured as pass-through entities, generating the bulk of the government’s tax revenues."