Understanding Changes in Flow-through Entities Due to Recent Tax Reforms

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Flow-through entities are a common legal business entity designation that protects business owners from double taxation. Tax professionals who work with individuals, small businesses, and large corporations must understand the laws and regulations associated with flow-through entities to protect their clients’ revenue.

The sweeping tax reforms introduced in 2017, known as the Tax Cuts and Jobs Act (TCJA), created a new tax deduction that applies to all types of flow-through entities. Veteran tax professionals and those new to the field should have a thorough understanding of the new laws so they can provide their clients with valuable advice.
The online master’s in taxation program from Northeastern University provides students with up-to-date, detailed information on the tax responsibilities associated with flow-through entities.

Before getting into the details, let’s take a closer look at the types of flow-through entities, their purpose within the U.S. tax system, and their importance to compliance standards.

How do flow-through entities function?

Flow-through, or pass-through, entities are not subject to corporate income tax, though the Internal Revenue Service does require that they file a K-1 statement annually. The most typical function of a flow-through entity is to ensure that its owners and investors are not subject to double taxation, which is the case for C-corporations. Additionally, owners of a flow-through business can use company losses against their personal income.

As with a C-corporation, flow-through entities must file their inventory accounting documents, depreciation records and profits. The main difference is that C-corporations are first taxed at the corporate rate, and then again when their shareholders receive capital gains. Shareholders of a flow-through entity, however, are only taxed at their individual income rate.

Flow-through businesses come in several forms, including:

  • Limited liability companies
  • Income trusts
  • S-corporations
  • Sole proprietorships
  • Partnerships

S-corporations typically pass their profits on to shareholders, who are required to report the income on Schedule E of their income taxes. Owners of sole proprietorships must report their business incomes and losses on their personal income taxes.

Why are flow-through entities important to the U.S. tax system?

Flow-through entities are the most common form of businesses in the U.S. When the tax reforms of 1986 passed into law, individual tax rates were lowered, making this type of business very attractive for many people. In fact, the number of pass-through businesses increased from 8.9 million in 1980 to 23.4 million in 2011, with S-corporations being the most popular option.

According to the most recent census data, flow-through entities employ 55.2 percent of all private sector workers. Most of these companies are small businesses with 50 or fewer employees. Considering the popularity of flow-through entities and their dominant presence within the U.S. tax system, tax professionals need to develop a deep understanding of how they operate. Even professionals who have been working with taxes for years have more to learn, as recent tax reform has changed how flow-through businesses are treated by the tax code.

How did TCJA impact flow-through entities?

In 2017, Congress passed the TCJA, which is considered the biggest change to U.S. tax law in decades. Virtually every aspect of corporate and individual taxation was impacted in some manner. Flow-through entities in particular were affected by a new 20 percent pass-through tax deduction. Though this deduction seems simple at first glance, complex rules govern who can take advantage of it.

The newly established Section 199A of the Internal Revenue Code specifies that the new deduction applies only to qualified business income. The IRS defines this as any income not produced by a trade or business that provides services through employees. For example, consulting firms, accounting firms, and law offices do not qualify for this deduction. However, an LLC that operates a restaurant would qualify because the shareholders in the LLC aren’t providing a service.

Businesses with qualified income are subjected to further restrictions for individual taxpayers who earn more than $207,500 or married couples who earn more than $415,000. In these cases, the deduction is calculated by one of these three formulas, whichever produces the lowest deduction rate:

  • 20 percent of qualified business income
  • 50 percent of W-2 wages paid from a qualified business
  • 25 percent of W-2 wages paid from a qualified business, plus 2.5 percent of the unadjusted basis of a qualified property

For example, let’s say Janet owns a pass-through entity that owns various investment vehicles. Her business earns $50,000 in qualified business income and generates $50,000 in capital gains. Janet’s deduction will therefore be either 20 percent of her qualified business income or 20 percent of her taxable income, less her capital gains, whichever is lower.

As this example illustrates, the new pass-through business deduction is anything but simple. Tax professionals who want to further their career options can learn about the complexities involved with this type of business in two courses in Northeastern University’s online Master of Taxation program:

  • Partners and Partnerships: This course provides an in-depth look at tax issues related to partnerships, including capital formation, operations, transactions, distributions, sales, and liquidations.
  • Advanced Flow-Through Entities: This high-level course offers students the opportunity to learn about and discuss the tax consequences of pass-through businesses, such a debt workouts, shareholder treatment, elections, and more.

Build your career in taxation

As the most popular type of business in the U.S., flow-through entities represent a significant topic that virtually all tax professionals will encounter throughout their careers. With recent reforms changing the way these businesses qualify for tax deductions, it is more important than ever that tax professionals refresh their knowledge of pass-through entity taxation.

In the 100% online Master of Science in Taxation from the D’Amore-McKim School of Business at Northeastern University, you can gain the skills and knowledge necessary for advancing your career. To learn more about the program, download a brochure here.

Recommended Reading:
How to choose between an online or on-campus master’s in taxation
Update on U.S. tax reform

Sources:
Northeastern University’s Online MST Curriculum
Flow-Through Entity
An Overview of Pass-through Businesses in the United States
Update on U.S. tax reform
What You Should Know About The New 20% Pass-Through Tax Deduction
What We Know About the 20% Pass-Through Tax Deduction (So Far)