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What You Need to Know About
How Your Partnership Is Taxed

© by Fred W. Daily

Next to the sole proprietor, the most common business entity is the partnership. Partnership provisions of the tax code apply even when two people go into business on a handshake and never sign a formal partnership agreement. As long as costs and profits of a venture are split, a partnership exists as far as the IRS is concerned. There is no federal partnership law; each state’s law governs partnership formation and operation.

Partnerships come in two varieties: "general" and "limited." The vast majority of small business partnerships are of the general variety. Here, each partner has a voice in the management of the business. Each can obligate the partnership to any contract, debt or other transaction within the scope of the partnership business. Be aware that each general partner is responsible for all of the debts of the partnership—liability is not limited just to the partner’s proportionate interest in the partnership.

The law is different for limited partnerships (LPs), which are primarily used to raise money from "passive" investors (the limited partners, but sometimes as family business vehicles. LPs must have two categories of partners: one (or more) general partners, who are personally liable for all business obligations, and one (or more) limited partners, who have no liability for partnership debts.

Let’s say Tom, Dick and Harry, ace mechanics, open up T, D & H Motorsports. Tom contributes tools, Dick has a building and Harry has 25 years experience but no money or tools. They agree to become a general partnership and split everything three ways. Should be simple when it comes time for taxes, right? Not exactly.

While you might think that a partnership means just splitting the profits and losses and reporting your share on your tax return, the tax code makes it much more difficult. While many sole proprietors can handle their tax chores without professional help; partnership accounting and tax law, is very complex. Bringing in a tax pro early on may prevent headaches later. The following short course may give you some idea of what I’m talking about.

The good news is that partnerships do not pay federal income taxes. Partnerships bear a tax resemblance to S corporations and limited liability companies. All three are "pass-through" entities, which means that the business owners—not the entity—pay taxes on business income. Partnerships must, however, file annual information type tax returns.

So far, so good. When it starts to get complicated is when the partners agree that profits and losses should be allocated unequally among partners. Maybe Tom and Dick don’t split profits and losses three ways, but 40% each to Tom and Dick and 20% to Harry. Under the tax code, that is not necessarily how each one is taxed. The next tax issue facing T, D & H Motorsport is that of the initial contributions of the partners to the partnership. The tax code frowns on a common situation where one partner, Harry, short on cash, but long on experience-- contributes a promise for future services. Harry cannot become a full partner under these circumstances. He must have contributed an asset or assets with present value to satisfy the tax code.

By: Frederick W. Daily, Tax Attorney,
John Raymond, Bankruptcy Attorney, and
Allan H. Rosenthal, paralegal.
All of the three have offices in San Francisco.

© 1997

(This article was originally written for tax practitioners who represent clients before the IRS. But the information presented here is valuable for all taxpayers.)

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