Explanation of Partnerships and Their Taxation
Like all business entities, the decision to launch a business as a partnership has its advantages and disadvantages as well as certain complexities.
To start, the IRS defines a partnership as: “the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.”
The latter part of the IRS definition underscores many of the partnership benefits. A partnership provides more initial capital than a sole proprietorship and generally greater management resources. Very simply, two heads are better than one… as are two wallets. The partnership brings with it fewer administrative burdens than a corporation, and income is taxed at the personal level, much like a sole proprietorship. This pass-through taxation is generally favorable, and there is flexibility in the income and loss allocations in a partnership.
However, also like a sole proprietorship, there is no liability limitation in a partnership unless a limited partner or limited liability partnership is created, in much the same way a sole proprietor can create an LLC to limit personal liability for protection against obligations generated by the business. Partnership business income may be subject to self-employment tax whether or not a partner is actively involved in the business, and partners have very few tax-deductible employee fringe benefits. Another partnership disadvantage is the complexity of basis adjustment rules and interest transfer.
For taxation, a partnership is a “flow-through” (or “pass-through”) entity. Unlike a corporation that is its own taxable entity, the partnership’s income is not taxed at the entity level. Instead, income flows through to the partners and is taxed as income on their respective personal levels.
Although the partnership itself does not pay taxes, it must file a return using IRS Form 1065. It must also provide Schedule K-1 to the IRS and to each partner that itemizes each partner’s share of the profit and loss. Partners then report this information on their personal returns. On the other hand, a C-corporation is effectively taxed twice: once at the corporate level as its own income-generating entity and again at the shareholder level when income is distributed.
A partnership does not need to be a 50/50 or otherwise even split regarding investing in the business. In many cases, it is not. For example, one partner may contribute and own 60 percent of the business (hence entitled to 60 percent of the business’s profit and loss) while the second partner may own the remaining 40 percent.
A partner’s initial basis typically reflects the amount of money or value of property contributed to the partnership or, in the case of purchased interest, the amount paid for the interest. Unless partners create a written partnership agreement, state law usually allocates the business profit and loss to partners based on their basis or ownership.
A partner’s basis is typically not static and may increase or decrease over time. According to the IRS, a partner’s basis “is increased by:
- The partner’s additional contributions to the partnership, including an increased share of, or assumption of, partnership liabilities.
- The partner’s distributive share of taxable and nontaxable partnership income.
- The partner’s distributive share of the excess of the deductions for depletion over the basis of the depletable property, unless the property is oil or gas wells whose basis has been allocated to partners.”
Conversely, a partner’s basis is “decreased (but never below zero) by:
- The money (including a decreased share of partnership liabilities or an assumption of the partner’s individual liabilities by the partnership) and adjusted basis of property distributed to the partner by the partnership.
- The partner’s distributive share of the partnership losses (including capital losses).
- The partner’s distributive share of nondeductible partnership expenses that are not capital expenditures. This includes the partner’s share of any section 179 expenses, even if the partner cannot deduct the entire amount on his or her individual income tax return.
- The partner’s deduction for depletion for any partnership oil and gas wells, up to the proportionate share of the adjusted basis of the wells allocated to the partner.”
Ending a Partnership
As you can imagine, there are various reasons to end a partnership, or if not ending it, re-adjusting its basis. Ideally, executing a dissolution will be cleanest if its steps have been clearly outlined in the original partnership agreement. The bottom line is all partnerships will end eventually either through the death of one or more partners or a decision for the partners to go their separate ways. Therefore, a written partnership agreement is necessary to have an amicable ending.
Two ways to remove a partner from a partnership are either through a partnership redemption or a purchase, and there is a distinct difference between them. While redemption by definition means to “buy back,” it is the partnership itself (as an entity) that buys back a partner’s interest in a redemption. On the other hand during a purchase (or sale), one partner (or a new partner) buys the partnership interest of the selling partner.
While this may seem a bit of “six of one, half dozen of the other,” there are tax consequences to be considered and pros and cons to either a redemption or purchase.
Partnerships may also close as the result of a technical termination: the sale or exchange of 50 percent or more of the capital and profits within a 12-month period (Section 708(b)(1)(B) vs. cessation to do business as a partnership under Section 708(b)(1)(A)). There can be many complex tax implications and severe penalties levied as a result of a technical termination. Partners want to avoid a technical termination when at all possible.
If you are considering creating a partnership or altering one that you may be in, please contact us to discuss the most prudent next steps. The professionals at Waddy Accounting Services can help you navigate the process and avoid making costly mistakes either now or in the future.