Partnership Taxation: Everything You Need to Know
Partnership taxation differs from that of other types of business entities. Partnerships (IRC §761) comprised of two or more members are not taxable entities. 9 min read
Partnership taxation differs from that of other types of business entities. Partnerships (IRC §761) comprised of two or more members are not taxable entities. The Internal Revenue Service recognizes partnerships as “pass-through” entities, established with partner contributions of money and property, in the interest of forming a business.
Income from partnerships is taxed at the individual level. Partners are obliged to report business income tax on profits and losses in the form of distributive or allocated income. Family owned businesses organized as family “limited” partnerships have certain tax advantages, especially in estate planning.
Like standard “limited liability company” LLC entities, partnerships are subject to “pass-through” rules to income reporting. This allows the entity to escape the double-taxation experienced by corporations. Dissimilar between LLC and partnerships is debt recourse, the former offering partners protection from debt recourse. Transfer of a partnership to a LLC or corporation ispossible and requires registration of the entity with the Secretary of State or Department of Commerce in the state where the entityis maintained. All U.S. states have adopted the Revised Uniform Partnership Act (RUPA),
The Legal Treatment of Partnership
The legal treatment of the partnership is that general partners do not have liability for the actions of other partners. Partnershipsare comprised of separate tax-paying partners. Income is channeled through owner income, business deductions, credits, and other items reported in individual tax returns. The partnership can elect a different tax year than the partners.
IRS Exclusion of Partnership Treatment for Federal Tax Purposes
Partnerships not conducting business can elect tobe completely or partially excluded from being treated as a partnership by the IRS for tax purposes if all partners agree to report income without the knowledge of the other partners. This loophole suggests that partnerships agreements can be written to consider partners solely as “joint-investors” or “co-owners” with separate entitlement. Limited duration partnerships are the most common IRS exclusion from being treated as a partnership.
Forming a Partnership
Partners can be individuals, estates, trusts, estates, associations, corporations, or another partnership. General partnerships are formed by agreement. Total capital investment in a partnership is equal to the net asset value of the partnership, or the remaining value minus payment of liabilities.
Distributive shares are the profit-loss interest of each partner determining annual allocations and tax for each partner. Distributive share is typically often proportional to the capital interest of a partner. Capital basis may also be determined by ratio of operating time, bond interest, or other value agreed to by the partners.
The Significance of Capital Accounts
Contribution of assets, cash, or services in exchange for partnership interest is the basis of equity in a partner’s capital basis, and percentage of ownership, and distributive shares (i.e. income). Allocations may vary according to annual profit and loss. Assumed liability by a partner is generally considered a contribution of capital in the amount of the liability.
Partnership Tax Reporting
Net income tax payments must be paid by the partners of a partnership. Since partnership is a “pass-through” entity, any amount partner does not withdraw from the partnership, increases that partner's basis. Quarterly taxes are filed April 15, June 15, Sept. 15, and Jan. 15 with Form 1040-ES. Distributions decrease a partner’s basis and are not taxed unless the partner receives income, and the amount exceeds the adjusted basis of the partnership. Profits retained are considered a return of capital.
A partnership must register for a federal employer identification number (FEIN) from the IRS.
Partnerships must file an annual Form 1065, U. S. Return of Partnership Income to report profits and losses. Schedule K-1, Partner's Share of Income, Deductions, Credits, is filed for each partner to report allocations and distributive income, losses, deductions, and credits incurred for the tax year. Reporting of capital gains by partners is filed on Scheduled D, Capital Gains, and Losses.
Partnership Interest and Taxable Value
The capital accounts of the partners must be continually adjusted to account for proper tax estimate in IRS reporting. Additional cash contributions or properties increase the tax basis of the partner making the contribution. Capital accounts are not affected by partnership debts. Gains and losses are deferred until liquidation of the partnership, or a partner sells interest. Loans made to the partnership are considered an asset with the proceeds offset by the liability of the debt.
Termination or Transfer a Partnership Interest
There are no tax implications for the partnership is an interest is sold to another partner. The selling partner may have gains as consequence of capital gains if that interest was longer than a single year. Sale of partnership interest must be reported to the IRS with Form 8308 – Report of the Sale of Exchange of Certain Partnership Interests.
Retiring partner capital interest is the first subtracted from the proceeds to calculate taxable income. A tax basis greater than the proceeds, can be deducted as a loss on investment. Debt relief is treated as income for retiring partners at time of sale. Retiring partners must be individual income tax on share of profits for the current tax year until sale is complete. Death is automatic withdrawal from the partnership unless otherwise stipulated in the partnership agreement.
The assets of a deceased partner become part of the member’s estate. Property of the partnership is distributed equally to the partners including retiring or recently deceased partners, with gains or losses accorded to the value of the property.
A partnership is effectively terminated when no part of the business is continued by any of the partners. A Partnership can also be terminated if at least 50 percent of the interest in the partnership's capital and profits is sold or exchanged within a year, even when the sale or exchange is to another partner. The latter does not apply to large partnerships classified as such with the IRS. Formal termination is when all transactions are complete, and the business has stopped. Partnerships terminated prior to end of tax year.
Transfer of a Partnership to a LLC
Transfer of a partnership to a “Limited Liability Company” LLC does not terminate the partnership agreement. However, recourse debt becomes nonrecourse debt, with the additional protections of the LLC. IRS tax reporting rules for LLC owners are the same as partners, both filing individual tax return reporting of business income based on an entity’s profit and loss. The LLC continues to use the taxpayer identification number of the partnership. The IRS imposes ratio of share of liabilities. The amount that exceeds the basis is considered a gain.
What forms do I use to file partnership income taxes?
The partnership files an IRS Form 1065 and Schedule K-1 for informational purposes only. Partners file Form 1040, and Schedule SE individual tax returns reporting income from partnership profit and loss, and any changes to quarterly estimated tax payments due to actual allocations.
IRS Form 1065 is the form used to calculate a partnership’s profit or loss. Questions about the nature of the partnershipare also requested in a Form 1065 filing.
Schedule K and Schedule K-1
Schedule K, Page 4 of Form 1065 breaks down income from partnerships into different categories. A Schedule K-1 is filed for each partner listing income for the year, including allocations, deductions, and tax rate for the year.
When are partnership income tax returns due?
Partnership income tax return information filing of Form 1065 and Schedule K-1 must be submitted by March 15 of the year following the tax year. Extensions must be filed by Sept. 15 of the same year.
How Partnership Income Is Taxed
The IRS considers partnerships to be “pass-through” entities, not obligated to tax reporting directly. Partnership income is taxed by way of the partners are responsible for individual return filing of profits and losses for the year.
Filing Tax Returns
Partnerships must file IRS Form 1065 record of profit and loss, and Schedule K-1 reporting of allocations associated with income distributed to partners. Each partner must report business income in an individual tax return filing of IRS Form 1040, with Schedule E self-employment reporting.
Estimating and Paying Taxes
Computation and the withholding of income taxes is the responsibility of partners receiving compensation from a “pass-through” partnership entity. Estimated quarterly tax withholding is the obligation of each partner. The IRS requires that partners estimate income tax withholding based on distributive share of profit and loss and not actual income received. Actual income allocated to partners is reported annually in a K-1 filing.
Profits Are Taxed Whether Partners Receive Them or Not
The IRS requires that partners pay individual business income tax on "distributive share." The portion the partner is entitled to under partnership agreement, distributive share of a business is not the same as allocations or actual income, which may vary annually.
Establishing the Partners' Distributive Shares
Distributive shares are established at the time of formation, in a written partnership agreement. Allocations of profits and losses to the partners deviating from the original agreement must be reported to the IRS for record of “special allocations” by the partnership. Partners are obliged to distributive shares in estimated quarterly tax payments and account for any differences between this estimate and allocations in annual IRS tax reporting.
The annual submission of IRS Schedule SE for self-employment reporting by partners of a partnership requires contribution to Social Security and Medicare. IRS guidelines to partnership provide for a 50 percent tax deduction of self-employment tax contribution.
Expenses and Deductions
Taxes are reduced by deductible expenses. Legitimate deductible expenses are start-up, operating, and marketing costs, as well as travel, meals, and entertainment. Schedule SE, the contribution to Social Security and Medicare automatically reduces total taxable income.
The reporting of income from a partnership is done for purposes of information only. Form 1065 reports profits and losses from a partnership. Reporting income “passed-through” to individual partners is submitted via Form K-1. Line 17 of the K-1 corresponds to the personal tax return 1040 filed by the partner. Partnership members typically pay quarterly taxes based on estimated tax amount owed prior topartnership submission of Form K-1 at the end of the year. Partners of partnerships are advised to set aside a sufficient sum to pay taxes.
The IRS taxes partners based on "distributive share," the percentage of the profits the partner is entitled to as an owner of the partnership. The K-1 clarifies the actual amount a partner receives, either according to partnership agreement or by allocation for the year.
The K-1 reports distributed income, including special allocation for purposes of information about the individual taxpayer, partners who are responsible for filing Form 1040, Schedule SE, and Schedule SE tax return information. Special allocation rules are complicated. Consult with a tax attorney or CPA before making changes.
Allocated Profit vs. Distributed Profit
Allocated share of a partnership’s profit is accounted for by default under federal IRS rules as “distributed” income unless an uneven allocation is otherwise reported. Although profits and losses in a partnership are not required to be split evenly between the partners, and the partners can choose to split the profit or loss in any way they choose.
Other Partnership Taxes
Partners must also file a Schedule SE for “self-employment” with Form 1040. Social Security taxes and Medicare contributions from SE reporting are in lieu of employer matched contributions.
Decreasing Your Tax Burden Through Deductions
Business expense deductions are often a large portion of a partnership’s revenue, serving to reduce your taxable income and taxes owed by a significant amount.
Self-Employment Tax for Partnerships
Business income from a partnership is subject to IRS Schedule SE self-employment tax at the individual level after it has been passed through to general partners. Filing of a K-1 by the partnership records allocations to partners is not a tax return and is for purposes of information only.
Are LLC's taxed differently from partnerships?
Taxation of LLC and partnerships are the same. Both “pass-through” entities, the members are responsible for distributed income tax reporting. The IRS does not recognize LLC as taxable entities, and all reporting by the company is for purposes of information about distribution to owners, exclusively. Both entities are responsible for filing K-1 with the IRS for reporting of distributed income. Owners are obliged to file individual tax return Form 1040, and Schedule SE.
Incorporating Your Business May Cut Your Tax Bill
Despite the double tax drawback of a corporation, taxed upfront at the entity level, and then again per shareholder at the individual level, partners are no longer responsible for filing individual tax returns on the company’s income, with exception of apportioned distribution of share dividends during years when retained earnings are not reported.
Forming a Corporation
Filing Articles of Incorporation with the Secretary of State forms a corporation. Transfer of a partnership to corporate status with the IRS has tax advantages. Additional tax rules apply large corporations.
Get Expert Help
A professional tax adviser specializing in partnership taxation can provide expert advice on the complex tax rules and the IRS application process.
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