Key Takeaways
- Partnerships are pass-through entities, which means its income is passed directly to the partners. So, instead of the partnership paying income taxes, the business’s income is reported on the partners’ personal tax returns.
- Partnerships must file Form 1065 annually. They also have to send a Schedule K-1 to each partner, which shows their share of the partnership’s profits or losses to report on their personal income tax return.
- While a partnership doesn’t pay federal income taxes, it has to pay employment taxes if it has employees (although the partners aren’t employees of the partnership).
- A partnership might have to file a state form similar to Form 1065. The business might also be able to file a “composite return” and pay state income taxes on behalf of its out-of-state partners.
Taxation of partnerships
Do you have a great business idea, but you’re not sure you can handle it alone? That’s where a partner or two might come in handy. They can bring additional skills, knowledge, or resources to the table and create a well-rounded team that’s better equipped to handle the challenges of starting a business.
And once you’ve found the right partners, perhaps you’ll consider forming a partnership. If so, you’ll have a lot of flexibility when it comes to deciding who will manage the business and how profits will be shared.
There’s also an important tax advantage that comes with a partnership. Since it’s a “pass-through” entity, the business’s income, losses, deductions, and credits are “passed” directly to the partners. This means the partnership itself doesn’t pay income taxes on its profits.
Instead, the partners report their proportionate share of the partnership’s income, losses, deductions, and credits on their own personal income tax returns. As a result, the business’s net income is ultimately taxed at each individual partner’s tax rate. (This can also include so-called “phantom income” that’s earned by the partnership, not distributed to the partners, but still taxable to the partners.) If there’s a net loss, the partners can generally use their share of the loss to offset their personal income from other sources and reduce their overall tax bill.
This method of taxation allows partnerships to avoid the “double taxation” associated with C corporations, where income can be taxed twice – first at the corporate level when the business files its annual tax return, and then again at the shareholder level on dividends paid by the corporation. That’s not the case with partnership taxes, where the business’s income is only taxed once at the partner level.
What is a partnership?
Before diving deeper into taxes on partnerships, let’s talk a bit more about partnerships in general.
A partnership is a type of business structure where two or more people or entities join forces to operate a business for profit. Partnerships allow for the shared responsibility of running a business, which means each partner can contribute their unique skills, knowledge, and resources to the business.
Partnerships are governed by a partnership agreement, which provides a lot of flexibility. Partners can agree on any terms they like regarding how the business is run, who makes decisions, and how profits are shared.
Types of partnerships
There are different types of partnership, such as general partnership, limited partnerships (LPs), and limited liability partnerships (LLPs). In a general partnership, partners are personally liable for the business’s debts and obligations. For example, if the business is sued or goes bankrupt, the partners might have to use their personal assets to cover what the business owes.
In a limited partnership, there are two types of partners – general partners who manage the business and have unlimited personal liability, and limited partners who invest in the business but have limited liability. A limited partner’s personal liability for business debts and obligations is generally limited to the amount of money or other property the partner contributes to the partnership.
With a limited liability partnership, all partners have limited liability for the debts and obligations of the business. However, some states only allow LLPs for certain types of professional businesses, such as law firms, accounting firms, and medical practices.
Limited liability companies
Although they’re not partnerships, the IRS treats limited liability companies (LLCs) with at least two members as a partnership for federal income tax purposes, unless the LLC elects to be taxed as a C corporation.
Federal tax filing and payment requirements for partnerships
Even though it’s the partners who pay federal income tax on a partnership’s income, the partnership itself is still responsible for filing certain tax forms and paying other taxes.
Let’s take a quick look at some of a partnership’s federal tax filing and payment requirements.
IRS Form 1065
Even though partnerships don’t pay federal income taxes, they still have to file Form 1065 with the IRS each year. The form is an informational return used to report the partnership’s income, gains, losses, deductions, and credits, as well as the amount of these items allocated to each partner.
Form 1065 is due on the 15th day of the third month after the end of the partnership's tax year (March 15 for calendar-year partnerships). As with other federal tax deadlines, this due date is moved to the next business day if it falls on a weekend or legal holiday.
In addition, the Form 1065 deadline is automatically pushed back six months (to September 15 for calendar-year partnerships) if the partnership requests an extension using Form 7004 by the original due date.
Schedule K-1
Partnerships also have to provide each partner with a Schedule K-1, which reports their share of the business's profits and losses. The partners then use the information on their Schedule K-1 to complete their personal income tax return. A copy of each Schedule K-1 is also filed with the IRS.
Each partner should receive their Schedule K-1 for the year by the due date of the partnership's 1065 form, which is March 15 for calendar-year partnerships. However, if the partnership is granted an extension to file Form 1065, the Schedule K-1 due date is also extended.
Employment taxes
A partnership is responsible for paying payroll taxes on its workers’ salaries and wages. This includes Social Security and Medicare taxes (FICA), as well as unemployment taxes (FUTA). Federal income taxes must be withheld from each employee’s paycheck and paid to the IRS, too.
However, it’s important to note that partners aren’t employees of the partnership. Instead, they’re considered self-employed when working for the partnership. As a result, the partnership doesn’t have to withhold or pay employment taxes for the partners.
On the other hand, the partners might have to pay self-employment taxes on their share of income from the partnership. General partners pay this tax on their distributive share of the partnership’s income or loss and guaranteed payments from the business. Limited partners only pay self-employment tax on guaranteed payments.
TurboTax Tip:
Partners can claim a tax deduction for 50% of the self-employment taxes they pay. The deduction is calculated on Schedule SE, which is also the form used to determine your self-employment tax.
Federal income taxes aren’t withheld from payments from the partnership to U.S. partners, either. As a result, domestic partners often have to make estimated tax payments to avoid IRS penalties for the underpayment of taxes. (Withholding on income allocated to foreign partners may be required.)
Excise taxes
Federal excise taxes are imposed on certain goods, services, and activities. There’s a wide variety of U.S. excise taxes, including taxes on:
- selling alcohol, tobacco products, and fuel
- driving trucks on highways
- sports gambling
- manufacturing various products, including fishing poles, tackle boxes, arrow shafts, and more
- indoor tanning services
- airline and ship passengers
As with other business types, if a partnership is involved in an activity subject to a federal excise tax, it will be responsible for paying the appropriate tax.
State taxes for partnerships
Don’t forget about state taxes. For instance, most states require partnerships to file an information return similar to IRS Form 1065. But the deadline for filing the state form doesn’t always line up with the due date for Form 1065 (including extensions). So, make sure you check with the state tax agency where you’re conducting business to determine the due date for your partnership.
Partnerships can also file “composite returns” in most states (they’re even required in some places). With a composite return, the partnership files a single state income tax return and pays state income taxes on behalf of certain nonresident partners. This simplifies state tax reporting and payment, since only one return for the partnership’s home state is filed instead of multiple returns from each out-of-state partner.
Some states require partnerships to withhold state income taxes from distributions to nonresident partners. A handful of states require withholding for certain resident partners, too.
In addition, most states allow partnerships to pay a special entity-level tax that can help the partners indirectly avoid the $10,000 limit on the federal deduction for state and local taxes. Payment of the special state tax will reduce the amount of money the partners would otherwise receive from the partnership. However, the partners receive a state tax credit, deduction, or exclusion to help offset the lost income.
State or local sales, property, excise, and/or other business taxes might have to be paid by a partnership, too.
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