Planning your favorite flow-through structure
Since flow-through entities pass through all items of income and deductions to the owners, planning consideration is placed on the structure of the business and how you could use that to a tax advantage. The following are just a few things to consider.
One of the major advantages to setting up your business as an S Corporation-beyond avoiding double taxation-is related to payroll. S Corporations pay employees, including shareholders, a reasonable salary and then distribute profits to the owners tax free, since all earnings have already been taxed to the shareholders. The disadvantages to S Corporations, however, include strict guidelines, costly setup, and state tax exposure. Special allocations are not permitted for profit and loss or distributions; therefore, if earnings are to be distributed they must be done pro rata. Due to the ability to take a reasonable salary and bonus each year, the shareholder can be given a bonus and allow for a compensation and payroll tax deduction lowering the taxable income distributed to the shareholders. In closely held S-Corporations, this may be a wise planning strategy to consider at year-end especially if it may benefit the company in state jurisdictions where the entity could potentially be subject to tax.
While one of the major advantages of LLCs and partnerships is their ability to limit the liability of the owners from debts of the company, they also bring the disadvantage of subjecting members/partners to not only income tax on the earnings but self-employment tax as well for general partners and managing members. Unlike S corporations, special allocations are permitted for profits, losses and distributions allowing more flexibility in structuring how and when distributions are made. When structuring such entities, whether a member/partner is a limited partner or is a general partner or managing member should be reviewed since this can have significant impact to the partner on a personal tax level.