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 states law governs partnership formation
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 partnershipliability is not limited just to the partners
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.
Lets 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
Im 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 ownersnot
the entitypay 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
dont 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.
(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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