In 2017, President Donald Trump signed a dramatic tax reform bill into law, fulfilling many of Corporate America’s biggest wishes.
For unincorporated business, the big headline changes - a lower corporate tax rate and a territorial tax system for international earnings - meant a whole lot of nothing. About 95 percent of U.S. businesses are flow-through entities, also known as pass-through entities, who don’t pay corporate taxes. So, a lower corporate tax rate doesn’t do much for them.
What you may not know is that flow-through businesses are not just mom-and-pop shops—they can be anything from a regional factory to a global accounting firm. That means excluding these business from tax breaks is a big no-no for legislators.So, lawmakers ensured there was something in the new tax code for flow-through business owners.
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If you’re about to start a manufacturing, distribution, or warehouse business, you’ve likely heard the term “flow-through business” floating around. But what exactly does this term mean, and how does it relate to all those other terms you’ve likely heard like “double taxation,” “LLC,” “S-corporation,” and “qualified business income?”
We’re ready to dive in with you, but we should say before we start: Tax law is complicated, interpreting it is even more complicated, and getting it wrong can be pricey. If you’re starting a business, you should consult with a qualified tax professional when choosing your business structure.
While you shouldn’t consider this article formal tax advice, do consider it a primer on what you need to know so you can ask the right questions.
Warehouse Flow Through Fundamentals
How Different Businesses Pay Taxes
When you work for a company, you’re a person who earns money and must pay a portion of these earnings to the Internal Revenue Service (IRS) in the form of income tax.
Similarly, businesses also earn income and the IRS expects a portion of their earnings as well.
If it were simply a matter of individuals and businesses, where a business was considered a “person” for legal purposes, this would be rather straightforward. Company A would earn money and this money would be taxed by the government. When the company pays a salary to its employees, these employees would have to pay a portion of these earnings to the government for their personal income tax.
Of course, because we’re talking about taxes and taxes are a pain, it isn’t that simple. There are several ways that a business can structure itself, and these structures determine how a business can operate and how tax laws apply.
If you’re starting a warehouse business, you have the following business structures to choose from:
- Sole proprietorship: An unincorporated business in which the owner and the business are legally the same entity. The business’s earnings are the owner’s personal earnings, and therefore they only pay personal income tax and self-employment tax (Medicare and Social Security).
- Partnership: A legal arrangement between two or more entities to run a business together and share the profits. In a partnership, the business earnings are divided up among the partners based on an agreement. Consequently, taxes are passed on to the partners and paid through their personal income tax. The business itself does not pay corporate income tax. The two most common types of partnerships are:
- General partnership: Liability is shared equally between partners.
- Limited liability partnership: Liability is limited so that partners are not liable for errors or wrongdoing of another partner. This is a particularly popular arrangement in areas like medicine where expensive malpractice suits can happen.
- Limited liability company (LLC): A hybrid between a sole proprietorship or partnership and a corporation. In this arrangement, individual partners are not on the hook for the company’s debts or liabilities. LLCs are administered under state law. Taxes are passed through to the “members” which can include individuals, corporations, and even foreign entities, depending on the state legislation. LLCs don’t pay income tax to the government. Instead, their members pay taxes through personal income tax.
- C Corporation: A legal entity distinct from the people who own it. From a legal standpoint, a C corporation is like its own person. It can borrow money and enter into contracts. Everyday people can own a piece of the company and benefit from the company’s success as shareholders, but they are not personally liable for the company’s debts or obligations. Corporations must pay taxes, although the corporate tax rate differs from the personal tax rate.
- S Corporation: A special arrangement that must first meet specific IRS requirements. In this scenario, a business receives some benefits of a corporation while also receiving the tax benefits of a partnership. In other words, they get the legitimacy of a corporation while passing the tax buck on to partners and shareholders. There are specific conditions a C corporation must meet before it can become an S corporation.
At the core of all these types of entities is an understanding of who pays taxes and who takes responsibility for debts and liabilities. In some cases, the business and the person are one and the same (sole proprietorship) so only one entity is on the hook for taxes, lawsuits, and debts.
In other cases, the business is its own person from a legal standpoint and has to pay its own corporate taxes (corporation), but its owners aren’t personally responsible for its debts.
In other cases, liability isn’t personal, but taxes are still passed through to individuals (partnership, limited liability company, S corporation). Scenarios like this are referred to as flow-through or pass-through businesses, so it could be said that they practice flow-through accounting or flow-through taxation.
To understand why this is, it’s important to understand the concept of double taxation.
What is Double Taxation and How Does It Relate to Flow-Through Taxation?
Double taxation typically occurs for one of two reasons:
- Income tax is paid twice. Once at the corporate level and a second time at the personal level.
- Two jurisdictions demand a cut. When international trades happen, money is taxed at the place of origin and at the destination.
For the purposes of this article, we’re going to focus on the first instance.
Why is income tax paid twice? Well, as we discussed, governments consider corporations their own legal entities for tax purposes. Let’s break it down with an example.
Let’s say that you own a national warehousing company and you’ve got distribution centers across the continental United States. At some point, you incorporated your business, because you wanted to start selling shares to finance your growth plans. You’re grateful to your shareholders for investing in your business, so rather than retaining all your earnings, you choose to distribute them in the form of dividends.
When you do this, your business will be subjected to double taxation.
- Your company earns money through the fees paid by people using your warehouses.
- On an annual basis, you pay a portion of these earnings to the IRS at the corporate tax rate. Today, the federal corporate tax rate is a flat rate of 21 percent.
- You distribute some of your earnings to your shareholders in the form of dividends. The government considers a dividend a form of income and income is taxable. As a result, your shareholders must pay tax on these dividends. The specific amount depends on whether the dividend is qualified or non-qualified.
Why is this considered double taxation? Well, your shareholders are technically part owners of this company, so they already paid taxes on this money when the company paid its corporate taxes.
In other words, Uncle Sam gets to double dip. To avoid this, companies set themselves up as flow-through entities.
When a business is a flow-through entity, money flows to the partners or members (for LLCs) as qualified business income. This is separate from any wages they may receive as part of the company.
What is Qualified Business Income?
Let’s say you and three associates enter into a partnership to run a warehouse business. For the purposes of this example, we’ll assume that you all take an equal share of the earnings (business income) and liabilities.
Now, you own a portion of this business and if you did absolutely nothing else but retain ownership, you would receive 25% of the earnings in business income. If the total earnings came to $400,000, you’d get $100,000 in qualified business income.
Let’s say you’re an electrician by trade and you decide to take on the electrical repair duties around the warehouse. You tell the other partners that you wish to be compensated for your time. They agree to pay you a $60,000 salary.
This salary is not qualified business income.
Your Wages: $60,000
Your Qualified Business Income: $100,000
When tax time comes along, you can report any losses against your qualified business income ($100,000) in the same way a corporation would. Moreover, you can apply the qualified business income deduction to that $100,000, so long as you meet specific requirements which we’ll address later.
The difference is that you do not pay the corporate tax rate on your qualified business income. Instead, you pay your personal tax rate on your qualified business income once it’s combined with your wages and any other income you earned that tax year.
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Should My Warehouse Business Consider Becoming a Flow-Through Entity?
After reading about double taxation, flow-through taxation sure sounds tempting. In fact, the standard wisdom, before the recent tax reform, was that if you’re starting a business you should choose a flow-through entity structure since proper incorporation is complicated, ,expensive and only worth it in specific scenarios.
Advantages of Operating as a Flow-Through Entity
The biggest advantage of flow-through entity status is a lower tax liability. In addition, the recent changes mean that eligible individuals’ flow-through business income will now receive a 20 percent deduction at tax time.
Jay Timmons, chief executive of the National Association of Manufacturers, told the New York Times, “A lower rate for pass-through entities is essential to ensuring small businesses are not left behind.”
Disadvantages of Operating as a Flow-Through Entity
Flow-through entity accounting can be a complicated and time-intensive task, especially if you’re consumed with reducing your business’s tax liability as much as possible.
Since the amount of tax paid depends on the business structure (e.g., general partnership, LLC, S corporation) and how the funds are distributed (e.g., capital gains, profits, or wages) there are all sorts of ways to rearrange business activities to limit the year’s tax bill.
In other words, businesses often spend valuable time trying to figure out how to pinch tax pennies. According to the Brooking Institute, “The effort, cost, and complexity of structuring businesses and business activities to minimize taxes is inefficient and wasteful.”
Moreover, if your business plans to retain its earnings to fuel future growth (with the assumption that the share price will increase as a result) it may make more sense to set yourself up as a C corporation.
Limitations of S Corporations
Some companies may opt for S corporation status because they want to sell shares, but there are limitations to this version of a flow-through entity, depending on your business’s specific structure.
For instance, S corporations must be domestic, have no more than 100 shareholders, only have domestic individuals and specific qualifying entities as their shareholders, and offer only one class of stock. Failing to meet these conditions make your S corporation status void and obligates your business to pay standard C corporation tax rates.
Finally, you will need to pay both the employee and employer portions of self-employment taxes. Self-employment tax covers your Social Security and Medicare contribution. In fairness, this also applies to sole proprietorships, partnerships, and LLCs.
Should You Become a Flow-Through Entity?
If you’re asking this question, it’s likely because you are either:
- Embarking on a new warehouse or manufacturing venture and want to choose the most tax-advantaged structure
- Currently running a small warehouse as a sole proprietor and need to change your ownership structure to limit your liability
- Currently have an incorporated business and are considering unincorporating to take advantage of flow-through accounting
While any decision should be made in conjunction with a tax professional, warehouse and manufacturing plant owners should consider the following when making their decision.
Do You Have Large-Scale Expansion Plans?
If you plan on expanding and selling multiple share classes, then incorporation may be your best option. A partnership can’t sell shares and, while an S corporation can sell shares, there are certain limitations on doing so:
- Can’t have more than 100 shareholders
- All shareholders must be U.S. citizens or U.S. residents
- Only allowed to distribute one class of stock, effectively assigning equal voting rights to every shareholder
Do The Changes to The Tax Code Make Incorporation More Beneficial For You?
Previously, the expensive corporate tax rate plus the double taxation predicament made the flow-through entity option a no-brainer for new businesses. However, recent changes in U.S. tax legislation have lowered the corporate tax rate. You should crunch the numbers with an accounting professional to determine which structure is most aligned with your business’s goals.
Does Your Personal Income Make You Ineligible For The Deduction?
Simply being a flow-through entity isn’t enough to qualify for the 20 percent deduction. The government introduced a number of rules and conditions to prevent business owners from taking advantage of the tax break.
If you earn less than $157,500 as a single-filer or less than $315,000 as a joint-filer, you’re automatically eligible for the 20 percent deduction. If you’re above this limit, there are certain factors that impact how much of a deduction you receive, including:
- Your W-2 limitations
- Your field, which encompasses “any trade or business involving the performance of services in the fields...where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees”
Understandably, almost any business depends on reputation and skill, so the IRS has released further clarification in this regard and listed the fields that may fall into this category including health, law, and accounting. Again, since it isn’t possible for the IRS to list every possible job or scenario, this is another instance where consulting with a professional is critical.
Operating as a Flow-Through Entity is a Safe Bet, But Post-2017 Tax Reform Offers New Options
In most cases, setting your warehouse up as a flow-through entity is a safe bet. Most businesses, including large companies, use this arrangement, and it helps you avoid double taxation. Then again, if you are someone who can’t stand the thought of missing out on a savings opportunity, the recent tax law changes may make incorporation a lucrative option.
Review the key changes to the tax law, consider your personal income (and that of your spouse if you file jointly!), and consult with a professional to ensure you pick the optimal structure for your personal and business goals.
Written by Ruthie Bowles
Ruthie is a content marketing consultant for Logiwa. Her specialties include small business development and inventory management.