When two or more individuals go into business together, one of the entity choices that are available to them is The Partnership. The Partnership is considered a separate entity from each individual partner. A formal agreement is not necessary to form the partnership; however, it is advisable to do so to avoid disagreements that could arise in the future. The partnership will not be taxed on its income or losses, but rather will act as a vehicle to pass this income or loss directly to the partners who own the business. A major advantage is that it can specifically allocate items of income and deductions directly to the partners and is not required to allocate these items in a pro-rata fashion. Thus in a partnership, an individual will be taxed on his or her allocated share of the partnership earnings or losses. The partnership profit or losses is reported on IRS Form 1065; and the amount allocated to each partner is reported on IRS Form K-1. The IRS Form K-1 will also tell the Internal Revenue Service how much, and what type of income or deduction to look for on each partner’s individual tax return.
Two popular forms of partnerships are the General Partnership and the Limited Partnership. In a General Partnership the partners are held liable for the partnership debt. If the partnership cannot pay its debts, creditors can come after one partner or all partners. A Limited partnership requires at least one general partner, but the rest can be limited partners. The limited partners are not liable for the debts of the partnership; however, they also cannot participate in the management of the partnership. The only exposure that they have is their investment in the partnership. If the partnership cannot pay its debts, they will have only recourse to go after the one general partner.
Partners are not considered employees of the partnership. General partners must pay self-employment taxes on their share of the income while limited partners are not required to pay self-employment income on their share of the income. As in Sole Proprietors, partners may withdraw money from the partnership. Since the partners pay money on the earnings as it is earned, this creates partner basis. The partner’s share of partnership liabilities also adds to the partner’s basis. A partner may withdraw money up to the amount of his basis in the partnership. If he withdraws money in excess of his basis, he will have to report a capital gain on the excess. It is best to consult a tax professional to explain all the implications of excess distributions.
To illustrate how a partnership works, let us go back to the same example presented in the Sole Proprietor article:
John Doe is a member in a general partnership. His portion of the 2015 partnership earnings is $75,000. He will be filing as a single taxpayer.
Since general partners are considered self-employed, he will be subject to self-employment taxes. As in the sole proprietor, his portion of the self-employment taxes will be $10,598. Also since he is considered self-employed, he will be able to deduct one-half of the self-employment taxes from his income to arrive at Adjusted Gross Income. Thus, his federal income taxes will also be identical to the sole proprietor of $11,644. Therefore, his total tax liability on his share of the partnership earnings will be $22,242 (see the Sole Proprietor article for illustration of how these amounts were computed).
Now let us take the same example except that John Doe is a limited partner in the partnership. His portion of the earnings is still $75,000. He will be filing as a single taxpayer.
Since limited partners are not subject to self-employment taxes, his 2015 tax liability on his $75,000 share of the partnership income is computed as follows:
As you can see his federal income tax on his earnings is slightly more than if he was a general partner ($11,644) due to the fact that he does not have to pay self-employment tax and therefore is not entitled to the deduction of one-half of the self-employment taxes in computing his taxable income. But also remember, he will not be able to be active in the management of the partnership.
In the next article we will explore the C Corporation as a form of business entity.