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How Are Partnerships Taxed?

You either already have a general partnership or are thinking of starting one and you’re wondering what the tax implications will be. Well, there’s good news and there’s bad news. The good news is that partners can report their income on their personal tax returns just as they normally would. Simple, right?

The bad news is that there are some extra hoops you’ll need to jump through to satisfy the IRS that this income is being correctly reported. Don’t sweat it though, the extra requirements aren’t too hard to meet, and this article will help clarify the rules around this and explain the basics of partnership taxes.

Pass-Through Taxation

Just as a sole proprietorship is the de facto business entity for a single individual doing business in his or her own name, a general partnership is the de facto business entity for two or more individuals doing business together that haven’t registered as a different entity with their state. So, similarly to a sole proprietorship, the IRS does not consider partnerships to be legally distinct from the partners.

This has its benefits and drawbacks. On one hand, the partners can be held personally liable for partnership debts, but on the other hand, the profits avoid being taxed twice as they would if the business were a corporation. Corporation profits get taxed once at the entity level and once again at the personal level after the profits are distributed to the shareholders. Since partnerships are not legally separate from their owners, profits only get taxed at the personal level.

What Are “Distributive Shares?”

Although not required by law, every partnership should have their fundamental rules and procedures spelled out in a written partnership agreement. You can think of a partnership agreement as a partnership’s constitution. It clearly defines:

  • who the partners are,
  • how much of the partnership each partner owns,
  • each partner’s role,
  • how profits and losses will be divided,
  • how a partner may exit, and
  • how the partnership may be terminated.

Failing to solidify these ground rules up front has caused many promising partnerships to go under in their first few years of operation.

Partnership agreements are also important because they say how and when profits may be distributed. This is where “distributive shares” come into play. Partners are taxed on their profits regardless if they receive them or reinvest them in the partnership. So your distributive shares are the profits that you as a partner are entitled to receive, whether or not you actually withdraw those profits out of the partnership. This means that it is important for the partners to keep this fact in mind so that they withhold the proper amount of taxes each year.

Partnerships that rely heavily on reinvesting profits can consider incorporating as a corporation, which may offer some tax benefits in this situation, but this isn’t always necessary.

Distributive Shares Correspond to Ownership Percentage

If a partnership agreement doesn’t specify otherwise, then state law requires that distributive shares correspond to each partner’s ownership percentage.

So if there are three partners with equal ownership interests, then their distributive shares will each be 33% of the net profits.

Estimated Taxes

Although the partners can report partnership income on their individual tax returns, paying their taxes works a little differently since there is no employer to withhold taxes for them. Partners are required to make estimated quarterly tax payments to the IRS and (usually) to their state governments as well. These rules are explained in more detail on the IRS website.

Filing Schedules K-1 and SE

Filing Schedule K-1

Another hoop each partner will have to jump through is filing Schedule K-1 with his or her tax returns. Schedule K-1 simply reports each partner’s share of partnership profits and losses and is filed along with the individual tax return, which needs Schedule E attached as well.

Partners and Self-Employment Taxes

In addition to income taxes, partners also have to pay self-employment taxes, which are reported on Schedule SE. These are for Social Security and Medicare, which normally get paid by employees as payroll taxes. Unfortunately, in an employment scenario the employer also matches these taxes for each employee. This means that partners must pay twice the amount normally paid by employees.

Deductions to the Rescue!

So how can your partnership survive when it has to pay all these taxes even when profits are being reinvested? There are a couple of deductions that make the partnership business model possible. First of all, the IRS allows partners to deduct half of their self-employment taxes from their taxable income. This helps balance out the fact that the partners are paying double the amount of Social Security and Medicare that they would pay as employees.

Secondly, and most importantly, partners can deduct all of their legitimate business expenses from their taxable income. There are some general categories of expenses that are considered “legitimate” by the IRS, including:

  • overhead and raw material costs,
  • business use of your car or home,
  • employee pay,
  • rent, and
  • certain taxes.

The bottom line is that partnerships that are running successful operations usually have no trouble flourishing despite this tax burden. The deductions available offset a significant portion of the taxes, and the additional reporting requirements are not very difficult to comply with once you get used to them, especially compared to the requirements imposed by the IRS for other business entities.

If you still find yourself struggling to understand your obligations, don’t forget that you can always contact a tax professional or the IRS itself for an explanation. With any luck, you’ll quickly find you and your partnership on the road to success and you’ll never look back!