S corporations and partnerships are flow-through entities. Generally, they do not pay income taxes. The income or loss flows through to their owners, to be reported by them on their individual income tax returns. Sole proprietorships are also considered flow-through entities. The difference is that sole proprietorships do not file separate tax returns, as do S corporations and partnerships, Form 1120S and Form 1065, respectively.

Then there’s an entity called the limited liability company (LLC). There’s no separate tax law for LLCs as there is for C corporations, S corporations, and partnerships. That’s because an LLC may be taxed as a partnership, as a corporation, or in cases where there’s only one owner, as a sole proprietorship. The owner (s) of the LLC elect how the LLC will be taxed. This is done at the time the LLC’s articles of organization are filed.

There are two very important things to remember about S corporations, partnerships, and LLCs taxed as partnerships:

(1) The income that flows out to the owners must be broken down by separately-stated items, i.e., capital gain income, interest income, ordinary income, Section 1231 gains or losses, charitable contributions deduction, Section 179 depreciation deduction, etc. Why do you think that is?

(2) In order to deduct losses that flow out to the owners, the owners must have tax basis in their ownership interests. Tax basis can be complicated. But to put it simply, you cannot deduct losses in excess of your investment (basis) in the flow-through entity.

Talk about two of the following three items: (a) the differences between partnerships and S corporations, (b) separately-stated items, or (c) the shareholder/partner basis limitation to deduct losses.

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