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How Taxes Affect a Partnership

For many small businesses, one of the most complicated and stressful aspects of the operations process is the act of calculating and paying business taxes. This process can become overwhelming when business owners consider employee withholding rules as well as finding and documenting the myriad of business deductions that can and cannot be applied to the business. While not immune from the complications of tax preparation, partnerships have various advantages over other businesses when it comes to simplicity.

A Partnership Is Not Taxed as a Business Entity

A partnership is not considered as a separate entity from the actual individual partners by the IRS for tax purposes. The partnership is considered a pass-through tax entity, which means that all of the profits and losses from the business operation pass through as a tax liability to the individual partners. This means that each partner is responsible for paying taxes according to their individual share of profits or losses on their individual tax returns.

While this can be a definite advantage when it comes to the complicated tasks of determining business tax liability, it does preclude each individual partner from enjoying certain tax benefits provided in corporation tax structures. Although the partnership is not taxed as a business entity, it still must file a Form 1065, which informs the IRS of the overall profits and losses of the partnership so the IRS can track the validity of each partner's individual return.

Partners Pay Taxes on Their Share of the Profit

The main drawback to the tax structure of the partnership is that taxes due on profits of the business are passed on to the partners even if they did not receive them. In other words, if the partnership makes a profit but the partners choose to leave a share of those profits in the business as operational capital, the partners are still liable for taxes on their individual shares of the business profit. This is due to the IRS rule regarding distributive shares that treats each partner as if they actually received their share of the profits each year whether they did or not. This is a consideration each individual must consider prior to signing a partnership agreement.

Partners are Considered Self-Employed

The other drawback to the tax structure of a partnership is that each partner is treated as self-employed by the IRS, thus they are liable for self-employment taxes such as social security and Medicare withholdings, which are doubled over that of normal employees to match employer contributions.

Expense Deductions

The good news is that partnerships qualify for expense deductions that can be applied against business profits, thus reducing the amount of profit that needs to be reported to the IRS.