Tax Advantages of a Partnership: Everything You Need to Know
The tax advantages of a partnership are the reason many entities opt to be classified as such.3 min read
The tax advantages of a partnership are the reason many entities opt to be classified as such. A partnership is one of four main business structures that you can choose from when starting a business. When choosing the best business structure for your company, the tax liability is an important consideration.
What is a Partnership?
A partnership is a business structure where two or more persons serving as co-owners of a business to create a profit. There are different types of partnerships that you can choose from when starting your business including:
- General Partnerships - A general partnership is the simplest partnership business structure and requires no special fees or forms to set up. In these types of partnerships, each partner has the protection of limited liability which means they are both separately and jointly responsible for the partnership's obligations. General partnerships have the added benefit of not having to pay an annual tax.
- Limited Partnership - In a limited partnership, a partner's liability is limited to the amount attached to their investment if they are not actively engaged in the day-to-day management of the firm. Partners have limited liability which means there may be differences in each partner's tax and legal obligations. One of the downfalls of a limited partnership is the fact that they can be required to pay an annual tax of up to $800 in some states.
Tax Benefits of a Partnership
A partnership is considered a pass-through tax entity. This means that the partnership does not pay income tax, but instead the profits pass-through the company and to the owners or partners. For tax purposes, a partnership is ultimately viewed as an extension of its owners.
Not only does income pass-through to each partner, but also the deductions and credits. This means that the profits are only taxed at a personal level. This helps a partnership avoid the double taxation that corporations face by paying corporate tax and then having to pay tax on their dividend shares.
Each partner will have the share of the company that they need to report on their tax return sent to them on a Schedule K-1. This will include a breakdown of:
- Their portion of the profits or income
- Business deductions they can take
- Gains they will need to report
- Their losses and credits
For example, charitable contributions made on behalf of the partnership still count as a tax deduction which passes through from the business onto each partners tax return based on their portion of ownership.
All partners will be considered equal in the eyes of the IRS unless there is a specific arrangement that states partners own different amounts of shares in the profits. This can give existing partners a tax break when a new partner comes in as the size of their taxable assets in the partnership will drop. Those just becoming a partner will want to make sure they account for the additional tax burden it will impose on them.
Another benefit of a partnership is that they are extremely more flexible than a corporation. This flexibility allows them to be able to allocate income in a disproportionate manner if they choose. They have the right to split:
- Voting right
An example would be two owners where owner X has 30% interest, and Y has a 70% interest. Profits could be allocated 60% of x and 40% for Y based on the skill set they bring instead of their level of contribution.
The IRS Section 704(a) allows for income, gains, losses, credits, and deduction to be allocated differently as long as it is based on the partnership agreement. It is important that the special allocation is done for a legitimate reason and not to simply lower one of the partner's tax liability.
Since a partnership is a pass-through entity, the owners will not have to pay estimated taxes as an owner of a sole proprietorship would. The partnership may have to pay quarterly estimated taxes if they expect to owe more than a $1,000 in tax liability at the end of the year.
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