Partnership Taxes

Partnerships play a crucial role in the small business landscape. They offer a unique business structure. In partnerships, business income, losses, deductions, and credits pass through to individual partners. Understanding partnership taxes is vital for optimizing your tax strategy. It's also important for minimizing tax liability.

Let's dive into the basics of partnership taxation. Learn why it's different and what you need to know to handle these taxes correctly below.

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The Basics of Partnership Taxation

In partnership taxation, the business itself doesn't pay taxes directly to the Internal Revenue Service (IRS). Instead, it's a pass-through entity. This means the profits and losses pass through to the individual partners. They then report this business income on their individual income tax returns. Each partner includes their share of partnership income or loss on their personal income tax return. 

Though a partnership doesn't pay taxes on its profits, it does declare its operating losses and profits to the IRS in Form 1065 for tax filing.

Each partner receives a Schedule K-1 form. This form shows their share of the partnership's income or losses. This method is different from corporations like C corps that pay corporate income tax on their profits. Through these forms, both the IRS and every partner are made aware of how much is owed to the IRS by each partner.

Even before you receive your Schedule K-1, you'll need to estimate the tax amount you owe. This is to be sure that you set aside a sufficient amount of money to pay your taxes.

Key elements like income tax rate, personal liability, and disclosures are crucial in partnerships. Unlike a sole proprietorship or limited liability company (LLC), where the sole proprietor or LLC faces personal liability, general partners in a partnership can be responsible for the business's debts. However, limited partners in a limited partnership have protection like an LLC. These structures allow owners to safeguard their personal assets.

Maximizing Deductions and Credits in a Partnership

Partnerships can reduce their taxable income by claiming deductions and credits. To reduce tax liability, it's important for business owners in a partnership to understand which deductions and credits apply to them. This includes expenses related to running the business, like office supplies and travel expenses. Expenses like rent, utilities, and salaries are deductible.

Partnerships can also enjoy tax credits. These credits are specific to their industry or for certain business practices. For example, this might include methods like energy efficiency improvements. Proper record-keeping and understanding of the available deductions and credits are key. It's important to keep good records. Get legal advice or consult a tax professional for accurate tax preparation.

Understanding Capital Gains and Distributions in Partnerships

When a partnership sells an asset for more than its purchase price, this results in capital gains. These gains are passed on to the partners and reported on their individual tax returns. Distributions are payments made to partners from the partnership. They can be in cash or property. Distributions are not considered salary or wages and have their own tax implications. It's important to understand how these distributions affect each partner's tax liability.

Distributive Shares

Whether each partner actually receives the amount stated on Form K-1 is irrelevant. The IRS taxes are based on a partner's distributive share. This share is the percentage of the profits the partner is entitled to. 

For example, if the partnership agreement states, or the partners simply agree, that a certain percentage of profits should stay within the partnership (e.g., to pay for expansion or overhead), this doesn't matter to the IRS. The focus is on what each partner's share ought to be. Otherwise, partnerships could retain profits to avoid paying taxes.

The partnership agreement determines the distributive share of each partner. In the absence of a written partnership agreement, the partnership's profits will be split evenly. For example, consider that a partnership agreement states that you will receive 70 percent of the profits and losses. It also states that your partner will be allocated the other 30 percent. Then, that 70/30 split will represent each of your distributive shares. 

If there's no written agreement, each of your distributive shares will be 50 percent of profits and losses.

Understanding Special Allocations in Partnerships

A special allocation is when a partnership decides to allocate shares of profits in a way that's different from that specified in the partnership agreement. It can also be when a partnership allocates shares unequally without a written agreement.

For example, if you've been splitting profits equally with your partner but then decide to split them 60/40 one year, you may do so. Your reason must be for a substantial economic reason, such as that your partner took an extended vacation and didn't work much. If it's not, the IRS determines that the change was made primarily to lessen the aggregate tax burden of the partners. Then, the IRS will reallocate the special allocation. You'll have to pay taxes according to your regular schedule.

Special allocation rules are complicated. You should consult a tax attorney or accountant before making such changes.

Other Partnership Taxes

There are several tax issues partners must consider when filing their tax returns. Partners are considered to be self-employed, not employees, and therefore need to file a Schedule SE with their Form 1040 to pay their self-employment taxes.

Because of this self-employed status, you're also responsible for paying your share of Social Security taxes and Medicare. Partners are responsible for paying double what a normal employee would pay because employers normally match employees' contributions. By being self-employed, you're both employer and employee, but their tax burden is reduced by the allowance of deducting half of the self-employment contribution from taxable income.

Get Professional Answers to Your Partnership Taxation Questions

Whether you're just starting your partnership and need a better understanding of your tax obligations or have other legal needs, it's often in your best interests to contact an attorney before making important legal decisions.

Get started today and find a tax law attorney with partnership experience.