Partnership Tax Issues
For partnership tax returns, paying taxes involves understanding difficult terms like "distributive share," "special allocation," and "substantial economic effect." Here, we clarify some of these complexities and explain the basics of how partnerships are taxed.
How Partnership Income Is Taxed
Generally, the IRS does not consider partnerships to be separate from their owners for tax purposes. Partnerships are therefore considered "pass-through" (aka "flow-through") tax entities. This means that all of the profits and losses of the partnership "pass through" the business and flow through to the partners, who pay taxes on their share of the profits (or deduct their share of the losses - pursuant to the loss deduction rules) on their individual income tax returns. Each partner's share of profits and losses is usually set out in a written partnership agreement.
Filing Tax Returns
Even though the partnership itself does not pay income taxes, it must file what's called an "information return" - which is Form 1065 with the IRS. Form 1065 is an informational return the IRS reviews to determine whether the partners are reporting their income/losses correctly. The partnership must also provide a Schedule K-1 to the IRS and to each partner, which breaks down each partner's share of the business's profits and losses. In turn, each partner reports this profit and loss information on his or her individual tax return (Form 1040), with Schedule E attached.
Partners - Estimated Taxes
Because there is no employer to compute and withhold income taxes, each partner should set aside enough money to pay taxes on his or her share of annual profits. Ideally, partners should estimate the amount of tax they will owe for the year and make quarterly payments to the IRS in the form of estimated taxes using Form 1040-ES.
Taxable Income Whether Partners Receive Distributions or Not
The IRS requires each partner to pay income taxes on his or her "distributive share." This is the portion of profits to which the partner is entitled under a partnership agreement - or under state law, if the partners didn't make a formal agreement. The IRS treats each partner as though he or she received his distributive share each year. This means that you must pay taxes on your share of the partnership's profits - regardless of how much money was actually withdrawn from the business.
The applicable significance of the IRS rule about distributive shares is that even if partners need to leave profits in the partnership - for example, to cover future expenses or expand the business - each partner will owe income tax on his or her rightful share of that money.
Establishing the Partners' Distributive Shares
Unless business partners make a written/formal partnership agreement that says otherwise, state law usually allocates profits and losses to the partners according to their ownership interests in the business. This allocation determines each partner's distributive share. For instance, if John owns 65% of a partnership and Jane owns the other 35%, John will be entitled to 65% of the partnership's profits and losses and Jane will be entitled to 35%. (In addition, state law assumes that each partner's interest in the business is in proportion to the value of his or her initial contribution to the partnership.)
It is possible to split up profits and losses in a way that is not proportionate to the partners' percentage interests in the business. These are called "special allocations" and you must carefully follow IRS rules when implementing special allocations.
Active Partners Are Subject To Self-Employment Taxes
If you are actively involved in running the partnership, the IRS requires you to pay "self-employment" taxes in addition to income taxes on all partnership profits allocated to you. Self-employment taxes consist of contributions to the Social Security and Medicare programs, similar to the payroll taxes employees must pay.
There are some differences between the contributions regular employees make and the contributions partners must make. First, because no employer withholds these taxes from partners' paychecks, partners must pay them with their regular income taxes. Also, partners must pay twice as much as regular employees, because employees' contributions are matched by their employers. However, partners can deduct half of their self-employment tax contribution from their taxable income, which lowers their tax bill a bit.
Partners report their self-employment taxes on Schedule SE, which they submit annually with their personal income tax returns.
Expenses and Deductions
You and your partners may deduct your legitimate business expenses from your business income, which will greatly lower the profits you have to report to the IRS. Deductible expenses have associated IRS rules to follow but some can include a certain amount of start-up costs, operating expenses, travel costs, and product and advertising outlays, as well as a portion of the money you spend on business-related meals and entertainment.
For more information about how we can help prepare your partnership accounting records and/or your partnership tax return, please contact us here.