Do Partnership Distributions Have to be Equal
Do partnership distributions have to be equal? Partner equity does not typically equate to equivalent investment contributions from all business partners.3 min read
Updated July 8, 2020:
Do partnership distributions have to be equal? Partner equity does not typically equate to equivalent investment contributions from all business partners. Instead, partners can make equal contributions to the company and possess equal ownership rights, but make contributions in a variety of different forms.
What Are the Three Common Ways to Take Money out of a Partnership?
There are three standard ways to take funds out of a partnership:
- Return of capital: Refers to principal payments back to the partners that exceed the growth of a business or investment.
- Distribution of income: The process of sharing the net income of a partnership between the partners in a proportion that aligns with the partnership agreement.
- Loan to partner: Refers to the process of borrowing money from the capital of the partnership.
What Are the Allocation Methods Used to Distribute Partnership Income?
In order to distribute partnership income, there are a number of ways to allocate the funds. These include:
- Specified ratios,
- Partners' service contributions,
- Partners' relative capital investments.
A combination of all of the different allocation methods can also be used.
What Is the Most Common Allocation Method?
The most common way partners allocate net income is through the relative capital investment of each individual. To clarify, if partner A and B each supply 50 percent of the capital then each person will receive 50 percent of the company's net income.
Is Unequal Distribution of Profits Allowed?
A partnership agreement may specify that unequal profit percentage is available to a partner and isn't dependent on the amount of his/her capital distribution. For example, if partner A and partner B both make initial capital contributions of 50 percent each, a partnership agreement can document the understanding that partner A receives 40 percent of the net profit while partner B receives 60 percent.
What Should Be Set up to Record Loans to Partners From the Partnership?
Borrowing from a partnership is allowed. This is completed by setting up a notes receivable account in order to record any loans that a partner takes from the partnership. The borrowing partner should prepare and sign a promissory note. The note should contain specific items regarding the loan, such as:
- The principal (the amount financed),
- Repayment date(s),
- Interest rates,
- Late payment penalties,
- Installment payment amounts.
Another option when taking money out of a partnership is to reclaim all or part of the initial capital investment.
Is a Return of Your Capital Taxable?
Returned capital is also not taxable. It is important to note that if you do decide to liquidate the partnership and receive an amount that is more than your capital investment, the excess is considered capital gain. It is considered a capital loss if you receive less than your initial investment.
Tax on Retained Earnings in a Partnership
In a partnership, the income passes through to the partners. This means that a partnership does not pay taxes, but rather the partners do. In fact, it is the responsibility of the partners to ensure that they pay tax on their income. Remember that what the Internal Revenue Service (IRS) considers income and what the members of a partnership declare as income may be widely different, especially when it comes to retained earnings. This refers to funds that have been generated by the business, but not taken out from the partners.
Retained Earnings as Income
When members leave profits in the partnership rather than withdrawing them, this is referred to as retained income. The IRS states that partners must pay taxes on this generated income because it is considered as distributed funds. Leaving retained profits in the business doesn't exempt the funds from being taxed. This is because partnerships do not get taxed, but the partners do. All retained earnings should be filed on each partner's Form 1040, which is one of three different IRS forms utilized for filing individual federal income tax returns.
Filing Form K-1 and Form 1065
There are specific forms that a partnership must complete when filing taxes. For example, a partnership must file a Schedule K-1 with the IRS and provide a copy to each partner. The Schedule K-1 Form reports each member's share of the losses and profits. These figures must correlate to members' claims on their personal income tax forms. The IRS will also require the partnership to complete Form 1065 to determine if all the partners are appropriately reporting their income.
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