Partnership Taxation

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If a group of two or more people carry on any sort of business without becoming incorporated, this is considered to be a partnership.

The Partnership Agreement

A partnership is governed by a partnership agreement, which specifies how the ownership percentages of the partnership are determined, and under what circumstances and payment plans partners can be bought out by the remaining partners. The partnership agreement can specify preferential returns for some of the partners. If the partnership agreement is not clear about how income is to be distributed, then it will be based on the partners’ relative contributions to the partnership. If there are variations in the proportional share of each partner during the tax year, perhaps due to additional contributions to the partnership, then the average share of each partner must be calculated and used to determine the proportional distribution of income amongst the partners at the end of the tax year; however, alternate arrangements for preferential returns, if specified in the partnership agreement, will override this calculation.

Partnership Taxation

Every partnership must file an information return on Form 1065 that specifies its taxable income at the end of the year, as well as the identity of each partner and the amount of the income that is attributable to each one. The partnership must issue Schedule K-1 of the Form 1065 to all partners on a timely basis, or else a penalty will be charged against the partnership for each K-1 form not issued. The K-1 form is used by each partner as a source of income or loss from the business that is then included in his or her personal income tax return.

Even if the profits from a partnership are not distributed to its partners, the profits are still taxable income to the partners. This generally results in a minimum distribution to the partners each year that allows them to pay their taxes, and which also keeps much money from accumulating within the business. If any funds are retained in the business rather than being distributed, they increase the capital contribution of the partners for tax purposes.

If a partnership experiences a loss, the share distributed to each partner will only be allowable to the extent that it offsets the adjusted basis in each partner’s partnership interest. If the amount of the loss exceeds the adjusted basis, then it cannot be deducted in that year, but may be carried forward for potential offsets against future increases in the interests of the partners. This principle is based on the concept that a partner cannot lose more than his or her total interest in the partnership.

Partners may have to make estimated tax payments during the course of the tax year as a result of income from a partnership. If so, the estimated tax must, at a minimum, be the smaller of 90% of the expected partnership income for the year, or 100% of the total tax paid in the preceding year. Also, partners are not counted as employees of a partnership, and so must pay a self-employment tax.

Partnership Elections

A partnership can make a number of elections regarding the reporting of income. For example, it can choose between the accrual, cash, and hybrid methods of accounting. It can also choose between two types of MACRS depreciation, various types of revenue recognition, and different approaches for recognizing organizational expenses. The main point is that the accounting methodology choices available to a partnership are the same as those available to a corporation.