Key Takeaways:

  • Limited Partnerships (LPs) have pass-through taxation, where profits or losses are reported on individual partners' tax returns rather than taxed at the business level.
  • General partners (GPs) are involved in daily operations and are subject to self-employment taxes, while limited partners (LPs), who invest without active roles, do not pay these taxes.
  • An LP’s losses can be used to offset other income on a partner’s tax return, up to the amount invested.
  • Limited partners benefit from limited liability and are typically only liable up to their investment in the partnership.
  • Partners in an LP can carry forward unused losses for up to 20 years or carry them back two years to offset previous gains.

A limited partnership tax return must be filed annually in order to report the income, deductions, losses, gains, etc., from a limited partnership's operations. Limited partnerships do not pay income tax. Instead, they will "pass through" any profits or losses to partners. Each partner will include their share of a partnership's income or loss on their tax return.

A partnership is created when two or more persons join together in order to carry on business or trade. Each person contributes labor, skill, money, or property into the company in order to share in the profits of the business.

What Is a Partnership?

A partnership occurs when a business is owned by several individuals that have agreed to a partnership agreement and have made the appropriate investments into the business.

Liability and Risk Management in Limited Partnerships

One of the defining features of a limited partnership is the structure of liability. General partners have full responsibility for the business’s liabilities and obligations, exposing them to higher financial risk. In contrast, limited partners are protected from liabilities beyond their investment amount, allowing them to participate without endangering personal assets.

This liability protection attracts investors who wish to benefit from the business's potential profitability but prefer limited involvement in day-to-day management and reduced risk exposure. For partners concerned about personal liability, limited partnerships serve as an appealing choice over other structures like general partnerships, where all partners face full liability.

How Are Limited Liability Companies Taxed?

A limited liability company (LLC) that has more than one member will usually be taxed as a partnership because the Internal Revenue Service (IRS) will not acknowledge the LLC as a business entity regarding tax purposes. Single-member LLCs are taxed as sole proprietorships and not partnerships. An LLC with one business owner must report income on Schedule C of its personal tax return.

What Are the Tax Implications of a Limited Partnership?

A general partnership operates similar to a limited partnership (LP). An LP business will have two or more partners; one is considered a general partner and the other is a limited partner who is a passive investor and not considered an active investor in the business. General partners (GPs) are responsible for the daily operations of the organization, while LPs do not have authority to dictate how the business is run. LPs are taxed similarly to partnerships with the pass-through taxation process. However, the roles of limited and general partners do impact the amount of tax that partners will pay.

The pass-through taxation method for LPs carries the profits and losses from the business to the individual tax returns of the partners. In turn, the partners are taxed based on their partnership agreements and are usually allocated based on the percentages of business ownership. For example, when an owner controls 50 percent of the business, they will receive 50 percent of the profits or losses.

A key benefit of an LP business is that pass-through taxation restricts profits from being taxed twice. Therefore, profits will be passed down to the partners' level and the organization will not be taxed. On the other hand, corporations are taxed at the business level and again when the shareholders receive any dividends.

A significant advantage of a corporate tax structure is the ability to retain earnings. A significant number of corporations may retain up to $250,000 in net profits from being appropriated out to stockholders. These funds may be used for building renovations, purchasing equipment, etc. Remember, the goal of pass-through taxation is to not retain earnings.

When a business incurs more losses than profits, the partners of an LP may deduct losses up to the amount that they've invested in the business. They may even carry any excess loss to prior and future years to offset any profitability during those periods. LPs have the ability to carry losses forward 20 years and back two years.

Limited partners do not actively take part in the day-to-day operations of the business, and therefore are not required to pay self-employment taxes. On the other hand, GPs must pay self-employment taxes, which are Medicare and Social Security taxes combined, accounting for about 15 percent of a partner's net income.

Advantages of Limited Partnerships for Tax Purposes

Limited partnerships offer specific tax advantages for both general and limited partners. One primary advantage is the ability to "pass-through" income, meaning that the partnership itself does not pay taxes; rather, each partner reports their share of the income or loss on their individual tax returns. This approach prevents double taxation, unlike corporate structures that tax income at both the corporate and shareholder levels.

Additionally, limited partners, being passive investors, avoid self-employment tax on their share of the income since they do not participate in the partnership’s operations. This exemption applies only to passive investors, so general partners managing the partnership must still pay self-employment tax. This tax treatment appeals to individuals or entities seeking to limit their tax obligations while maintaining liability protection up to their investment.

How Are Partnerships Taxed?

Partnerships are not required to pay federal income tax. Rather, a partnership's net income/loss is passed through to the individual partners themselves, who must then report and pay taxes on their personal income tax returns. Unless the partnership does not have any income or expenses, it is required to file an annual tax return. The submitted return will acknowledge the partnership's:

  • Total income.
  • Total deductions.
  • Total credits.
  • Each partner's share of the business.

Remember, partnerships may be required to file and pay state taxes. GPs and LPs will follow similar procedures for filing taxes. However, LPs are subject to a marginally distinctive tax treatment when compared to GPs.

Reporting Requirements and Filing Deadlines for Limited Partnerships

Limited partnerships are required to file IRS Form 1065, the U.S. Return of Partnership Income, annually. This form reports the partnership's total income, deductions, gains, and losses. Each partner receives a Schedule K-1, which outlines their individual share of the partnership’s financial details. Partners then use this form to report the relevant amounts on their tax returns.

The filing deadline for Form 1065 is March 15th each year, or the 15th day of the third month following the close of the partnership's fiscal year. If more time is needed, partnerships can request an automatic six-month extension by filing IRS Form 7004 before the original due date.

Deductions and Credits in Limited Partnerships

Limited partnerships have flexibility in using various deductions and credits to lower taxable income. For example, partnerships can claim business-related deductions, including expenses for property, equipment, or other operational costs. Additionally, if the partnership qualifies, it may apply specific credits, like the Research and Development (R&D) tax credit or the Work Opportunity Tax Credit (WOTC).

Partners may deduct their share of the business’s net operating losses, subject to limitations based on their investment. Losses not used in a particular tax year can be carried forward to offset future income or, in some cases, carried back to amend prior years' returns.

Frequently Asked Questions

1. Do limited partners in an LP have to pay self-employment taxes?No, limited partners do not pay self-employment taxes on their share of the income, as they are considered passive investors without involvement in daily operations. However, general partners do pay self-employment taxes.

2. What form does a limited partnership file for tax purposes?A limited partnership files IRS Form 1065, which reports the partnership’s income, deductions, gains, and losses. Each partner also receives a Schedule K-1 to report their share on their individual tax returns.

3. Can limited partners use losses from the partnership on their personal tax returns?Yes, limited partners can use their share of the partnership's losses to offset other income, up to the amount they invested. Unused losses can be carried forward up to 20 years or back two years to offset past gains.

4. What is the tax deadline for filing a limited partnership return?The tax filing deadline for a limited partnership is March 15th, or the 15th day of the third month after the end of the partnership's fiscal year. An extension can be requested by filing Form 7004.

5. Are there tax credits available to limited partnerships?Yes, limited partnerships can qualify for certain tax credits, such as the Research and Development (R&D) credit and the Work Opportunity Tax Credit (WOTC), which can help reduce the partnership’s taxable income.

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