Key Takeaways

  • Partnerships are pass-through entities, meaning profits and losses flow directly to partners' personal tax returns, avoiding corporate double taxation.
  • General partnerships offer simplicity with minimal setup, while limited partnerships offer liability protection for passive investors.
  • Income, deductions, and credits are reported via Schedule K-1 for each partner.
  • Partnerships can use special allocations to distribute profits disproportionately, provided it's consistent with IRS rules.
  • Flexibility in structuring ownership and operations is a major advantage of partnerships.
  • Estimated tax payments may apply if the partnership's annual tax liability exceeds $1,000.
  • Other advantages include fewer regulatory requirements, shared responsibilities, and access to pooled capital and skills.

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:

  • Ownership
  • Income
  • 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.

Additional Advantages of a Partnership Structure

In addition to tax benefits, there are several other advantages of partnership business structures that make them an attractive option for entrepreneurs:

  • Shared Expertise and Resources: Partnerships allow multiple individuals to contribute varied skills, capital, and connections. This diversity often leads to more effective management and decision-making.
  • Simple Tax Filing Requirements: Compared to corporations, partnerships are generally easier to maintain with fewer compliance burdens and formalities. While partnerships must file an annual informational return (Form 1065), they do not pay corporate taxes.
  • Reduced Startup Costs: Partnerships usually cost less to form and operate. There are typically fewer fees, and the partners can split expenses, reducing the financial burden on any one party.
  • No Employment Tax on Distributive Share: Unlike a corporation where owner salaries may be subject to employment taxes, partners in a partnership are not considered employees. Therefore, their share of profits is not subject to self-employment tax in the same way (although general partners still pay self-employment tax on their share of earnings).
  • Capital Accumulation: A partnership can raise capital more easily than a sole proprietorship by adding new partners. This access to additional resources can help the business grow and scale.
  • No Corporate Formalities: Partnerships are not required to hold annual meetings or maintain extensive records like corporations are. This reduces administrative overhead and gives partners more flexibility in management.

These operational and tax advantages of partnership entities make them especially suitable for small businesses, family enterprises, or professional groups (like law firms or medical practices) that prioritize collaboration and tax efficiency.

Estimated Taxes

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.

Drawbacks to Consider with Partnerships

While the advantages of partnership structures are significant, potential disadvantages should also be taken into account:

  • Unlimited Personal Liability: In a general partnership, each partner is personally liable for the debts and obligations of the business. This risk can be mitigated in a limited partnership, but not eliminated.
  • Disputes Among Partners: Shared control can lead to disagreements, especially if the roles and responsibilities are not clearly outlined in a partnership agreement.
  • Tax Implications for New Partners: Adding a new partner affects profit distribution and can increase the tax burden for the incoming partner.
  • Self-Employment Tax: General partners must pay self-employment tax on their share of the business's income, which includes both Social Security and Medicare taxes.
  • Dissolution Complexities: Dissolving a partnership can be more complex than terminating a sole proprietorship, especially if there is no written agreement guiding the process.

Despite these issues, many of them can be addressed by creating a detailed and well-structured partnership agreement upfront.

Frequently Asked Questions

1. What are the main tax benefits of a partnership?

Partnerships are pass-through entities, so income, deductions, and credits flow directly to the partners’ personal tax returns, avoiding corporate taxation.

2. Do partners in a partnership have to pay self-employment taxes?

Yes, general partners must pay self-employment tax on their share of the partnership's income. Limited partners may be exempt unless they actively participate in management.

3. How are profits split in a partnership?

Profits are typically split according to the partnership agreement. Partners can choose to distribute income disproportionately based on value contributed, not ownership percentage.

4. Is forming a partnership expensive?

Generally, no. Partnerships are less costly to form and maintain than corporations and have fewer legal formalities and fees.

5. Can a partnership have unequal ownership and profit distribution?

Yes, under IRS Section 704(a), partnerships can use special allocations to distribute profits and losses unequally, provided the allocations are valid under the partnership agreement.

If you need help with the tax advantages of a partnership, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.