How Partnerships are Taxed

For many small businesses, paying income tax means struggling to master double-entry bookkeeping and employee withholding rules while ferreting out every possible business deduction. For partnerships, paying taxes also involves understanding difficult terms like “distributive share,” “special allocation” and “substantial economic effect.”

Here, we explain the basics of how partnerships are taxed.

How partnership income is taxed

Generally, the IRS does not consider partnerships to be separate from their owners for tax purposes; instead, they are considered “pass-through” tax entities. This means that all of the profits and losses of the partnership “pass through” the business to the partners, who pay taxes on their share of the profits (or deduct their share of the losses) on their individual income tax returns. Each partner’s share of profits and losses is usually set out in a written partnership agreement.

Filing tax returns

Even though the partnership itself does not pay income taxes, it must file Form 1065 with the IRS. This form is an informational return the IRS reviews to determine whether the partners are reporting their income correctly. The partnership must also provide a “Schedule K-1” to the IRS and to each partner, which breaks down each partner’s share of the business’ profits and losses. In turn, each partner reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.

Estimating and paying taxes

Because there is no employer to compute and withhold income taxes, each partner must set aside enough money to pay taxes on his/her share of annual profits. Partners must estimate the amount of tax they will owe for the year and make payments to the IRS (and usually to the appropriate state tax agency) each quarter — in April, July, October and January.

Profits are taxed whether partners receive them or not

The IRS requires each partner to pay income taxes on her/his “distributive share.” This is the portion of profits to which the partner is entitled under a partnership agreement — or under state law if the partners didn’t make an agreement. The IRS treats each partner as though s/he receives his or her distributive share each year. This means that you must pay taxes on your share of the partnership’s profits — total sales minus expenses — regardless of how much money you actually withdraw from the business.

The practical significance of the IRS rule about distributive shares is that even if partners need to leave profits in the partnership — for instance, to cover future expenses or expand the business — each partner is liable for income tax on her or his rightful share of that money. (If your business will regularly need to retain profits, you should consider incorporating — corporations offer some relief from this tax bite. To learn more, see “Incorporating Your Business May Cut Your Tax Bill,” below.)

Establishing the partners’ distributive shares

Unless business partners make a written partnership agreement that says otherwise, state law usually allocates profits and losses to the partners according to their percentage interests in the business. This allocation determines each partner’s distributive share. For instance, if Andre owns 60% of a partnership, and Jenya owns the other 40%, Andre will be entitled to 60% of the partnership’s profits and losses, and Jenya will be entitled to 40%. (In addition, state law assumes that each partner’s interest in the business is in proportion to the value of his/her initial contribution to the partnership.)

If you’d like to split up profits and losses in a way that is not proportionate to the partners’ percentage interests in the business, it’s called a “special allocation,” and you must carefully follow IRS rules.

Self-employment taxes

If you are actively involved in running a partnership, in addition to income taxes, the IRS requires you to pay “self-employment” taxes on all partnership profits allocated to you. Self-employment taxes consist of contributions to the Social Security and Medicare systems, similar to what employees must pay.

There are some differences between the contributions regular employees make and the contributions partners must make. First, because no employer withholds these taxes from partners’ paychecks, partners must pay them with their regular income taxes. Also, partners must pay twice as much as regular employees, because employee contributions are matched by their employers.

The self-employment tax rate for 2002 was 15.3% of the first $84,900 of income and 2.9% of everything over $84,900. You’ll need to research the current year’s rates. Partners report their self-employment taxes on Schedule SE, which they submit annually with their 1040 income tax returns.

Expenses and deductions

You may be wondering, after paying income taxes, Social Security taxes and Medicare taxes on your share of business income — even if you don’t withdraw it out from your business — just how you will survive! Luckily, you don’t have to pay taxes on just about any money your business spends to make a buck.

You and your partners can deduct your legitimate business expenses from your business income, which will greatly lower the profits you have to report to the IRS. Deductible expenses include start-up costs, operating expenses and product and advertising outlays, as well as business-related meals, travel and entertainment expenses.

Get expert help

If you’re confused by partnership taxes, you’re not alone. A good way to learn the basics is to read Tax Savvy for Small Business, by tax attorney Fred Daily (Nolo). Then, plan to get the help you need from a tax advisor who specializes in partnership taxation — to make sure you comply with the complex tax rules that apply to your business and stay on the good side of the IRS.

Incorporating your business may cut your tax bill

Unlike a partnership, a corporation is a separate entity from its owners and pays its own taxes on all corporate profits left in the business. Owners of corporations pay income taxes only on money they receive as compensation for services (salaries and bonuses) or as dividends.

While many small businesses would rather not file a more complicated corporate tax return, incorporating can offer business owners a tax advantage over a partnership’s “pass through” taxation. This is especially true for businesses that expect to retain profits in the business from year to year.

If you need to keep profits (called “retained earnings”) in your business, you may benefit from lower corporate tax rates, at least for the first $75,000 of profits per year. For example, if your retail outfit needs to stock up on expensive inventory, you might decide to leave $30,000 in your business at the end of a year. If you operate as a partnership, these retained profits will likely be taxed at your marginal individual tax rate, which is probably over 27%.

But if you incorporate, that $30,000 will be taxed at a lower 15% corporate rate. To get a better idea of whether you should incorporate to reduce taxes, see How Corporations Are Taxed.