A partnership is one of several legal business entities and, as such, can lead to certain tax issues.
What Is A Partnership?
Partnerships are a very common type of small business. A partnership is an agreement by two or more persons to conduct a trade or business. There can be an unlimited number of partners. While not required, an Operating Agreement should be in place detailing the partners’ responsibilities and ownership percentages (which may or may not be equal).
The Internal Revenue Service (IRS) recognizes five entities for tax purposes. Each type has many advantages and disadvantages.
| Business structure | Ownership | Liability | Taxes |
|---|---|---|---|
| Sole proprietorship | One person | Unlimited personal liability | Self-employment taxPersonal tax |
| Partnerships | Two or more people | Unlimited personal liability unless structured as a limited partnership | Self-employment tax (except for limited partners)Personal tax |
| Limited liability company (LLC) | One or more people | Owners are not personally liable | Self-employment taxPersonal tax or corporate tax |
| Corporation – C corp | One or more people | Owners are not personally liable | Corporate tax |
| Corporation – S corp | 100 people or fewercertain trusts and estatesno partnerships, corporations, or non-resident aliens | Owners are not personally liable | Personal tax |
| Corporation – benefit corporation | One or more people | Owners are not personally liable | Corporate tax |
| Corporation – Nonprofit | One or more people | Owners are not personally liable | Tax-exempt, but corporate profits can’t be distributed |
How Are Partnerships Taxed?
The partnership does not pay taxes.
Instead, the profit or loss of the partnership “passes through” to the individual partners each year in shares (not necessarily equally) determined by them. The partners then pay taxes on their personal returns, taking into account the business’s profits or losses.
If the business makes a profit, the partners are also subject to self-employment taxes on their personal tax returns. Self-employment taxes are the partners’ way of paying payroll taxes since they are not employees of the company.
Furthermore, the partner must pay 15.3% of the self-employment income (the business’s net profit). The partner can also deduct one-half of these taxes (technically the business’s share) on their personal tax return. The tax rates <insert table below> are the same as sole proprietorships.
What Tax Form Does a Partnership File?
The partnership files a federal Form 1065, an information return. It provides information to each partner regarding their share of the income and deductions incurred by the partnership. Each partner receives a Schedule K-1 detailing their specific share of these items.
When Is the Form Due?
The form is due by the 15th day of the third month after the partnership’s year-end.
This is typically March 15 of the following year for a tax year ending on December 31. A six-month extension is available to file the return.
Please note: Any extension is merely an extension of time to file the return, not an extension of time to pay.
Estimated Taxes for a Partnership
Since the partnership does not pay taxes, it is not required to make estimated payments. However, since profit and loss passes through to the partners, and they are subject to taxes on those amounts plus self-employment taxes, they may have to make individual estimated tax payments related to their personal tax returns.
Estimated tax payments for individuals are due each quarter on April 15, June 15, September 15, and January 15 (of the following year). These estimates must reflect both the income and self-employment taxes.
Payroll Taxes for a Partnership
Partners generally receive guaranteed payments or distributions that are not considered payroll and thus are not subject to payroll taxes, even if they perform services usually associated with being employees. They will be subject to self-employment taxes on their individual tax returns. The partnership is responsible for payroll taxes on the salaries, wages, and other compensation of all non-partner employees.
The partners are responsible for withholding these taxes, matching any required by law, and remitting these amounts to the appropriate taxing agency on time. Payroll taxes can be a significant cost of doing business, with potential ramifications on cash flow, and should not be ignored.
How are distributions from a partnership taxed?
In general, distributions to partners from the partnership are considered either a return of capital contributed by the partners or a distribution of profits earned from the normal course of business. The distribution itself is not taxable if it doesn’t exceed those total amounts. This is a complicated issue beyond the scope of this discussion. Please consider consulting a tax professional, such as a Certified Public Accountant, for further information.
What are the tax advantages of a partnership?
Certain legal and operational benefits of forming a business as a partnership may exist, but this is normally an issue better discussed with an attorney. From a tax standpoint, the tax treatments discussed above are generally not favorable to the actual taxpayers (the partners).
If tax minimization is the only motivation for forming a partnership, there are almost always better options, such as an S-Corporation election or even forming a regular C-Corporation. Again, it is recommended that you consult both a tax professional and an attorney before choosing this form of business.