Posted by The TaxAdvocate Group, LLC

Partnership Taxation & What You Need to Know

Partnership Taxation & What You Need to Know

For several small businesses, paying income tax means striving to master the rules of double-entry bookkeeping and employee withholding while researching all possible business deductions. For businesses, paying taxes also means understanding difficult terms like "distributive share," "special allocation," and "substantial economic effect." Here we explain the basics of partnership taxation.


How partnership income is taxed

In general, the IRS does not consider partnerships to be separate from their owners for tax purposes; rather, they are "temporary" tax entities. This means that all profits and losses from the partnership "pass" through the business to the partners, who pay profit-sharing taxes (or deduct their share of losses) in individual tax returns. Each partner's share of profit and loss is usually defined in a written partnership agreement.


Filing Tax Return

Although the partnership as an entity does not pay income tax, you must submit Form 1065 to the IRS. This form is the feedback that the IRS reviews to determine if partners are correctly reporting their income. Also, the partnership must provide a "Schedule K-1" to the IRS and each partner, describing each partner's share of the company's profit and loss. In turn, each partner reports this profit or loss information on Form 1040, with Schedule E attached.


Estimation and payment of taxes

Since no employer can calculate and withhold income tax, each partner must allocate enough money to pay tax on their annual income share. Partners must estimate the amount of taxes owed during the year and make payments to the IRS (and generally the relevant state tax agency) quarterly in April, July, October, and January.


Profits are taxed whether the partners receive them or not.

The IRS requires that each partner pay income tax on "distributive shares." According to state law, this is the share of the income to which the partner is entitled under a partnership agreement or, according to state law, if the partners have not reached an agreement. The IRS treats each partner as if they received their distributive shares each year. This means that you have to pay taxes on the partnership's profit-sharing (total sales minus expenses), regardless of how much you take out of the business.

The practical meaning of the IRS distributive shares rule is that while partners are required to leave profits in the business, for example, to cover future expenses or to grow the business, each partner is responsible for income tax on the corresponding part of his/her rightful share of the money. (If your business needs to maintain profits regularly, you should consider incorporating; corporations offer some exemption from this tax reduction.)


Implementation of the partner's distributive shares 

Unless the business partners enter into a written partnership agreement that provides otherwise, state law generally allocates partners' profits and losses based on their share of ownership of the business. This distribution determines the distributive share of each partner. For example, if John owns 60% of a business and Jane owns the remaining 40%, John will be entitled to 60% of the profit and loss of the business, and Jane will be entitled to 40%. (State law also assumes that each partner's interest in the business is proportional to the amount of the initial contribution to the partnership.)

Suppose you want to divide your profits and losses in a way that is not proportional to the percentage of members' ownership in the business. In that case, this is called a "special allocation," and you must follow the IRS rules carefully.


Self-employment taxes

If you are an active partner in a partnership, in addition to income tax, the Internal Revenue Service (IRS) requires you to pay taxes "on your own account" on all income associated with the partnership. Self-employment taxes consist of contributions to social security and health insurance systems, similar to what employees pay.

There are some differences between regular employee contributions and partner contributions. First, since no employer levies these taxes on the partners' payment slips, they must pay them with normal income tax. In addition, partners must pay twice as much as regular employees because employee contributions are equal to those of their employers.

The partners declare their taxes for their account in Schedule SE, which they submit annually with 1040 tax declarations.


Expenses and deductions

You might be wondering, after paying income taxes, social security taxes, and health insurance taxes on your share of the business income, even if you do not withdraw it from the business, how will you survive! Fortunately, you don't have to pay taxes on the money your business spends to make money.

You and your business partners can deduct legitimate business expenses from business income, greatly reducing the income that must be reported to the IRS. Deductible expenses include operating expenses, start-up costs, and product and advertising expenses, as well as food, travel, and entertainment expenses.


Get expert help

If you are confused by partnership taxes, you are not alone. A good way to avoid mistakes is by getting help from a tax advisor that understands and follows the complex tax rules that apply to your business to keep you on the safe side of the IRS.


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