Taxation of Partnerships
A partnership (IRC §761) consist of 2 or more people, or other entities, who contribute money and property to start a business. A partnership — like an S corporation or a limited liability company — is a flow-through business entity, where profits and losses flow to the individual partners. The partnership itself is not a taxable entity, although it must file an informational tax return. Except for the members of limited liability companies and limited liability partnerships, each partner is personally liable for all debts of the partnership. However, certain organizations — listed in the instructions for Form 8832, Entity Classification Election, such as insurance companies, tax-exempt organizations, and even real estate investment trusts, formed after 1996 — cannot be classified as a partnership for federal tax purposes.
Spouses who own a qualified entity in a community property state can be classified as a partnership by filing the appropriate forms or the spouses can choose to be treated as a sole proprietorship by filing Schedule C, Profit or Loss from Business. A qualified entity is an entity wholly owned by the spouses as community property, is not treated as a corporation, and no one other than the spouses have an ownership interest in the entity.
Although partnerships are governed by state law, the states have all adopted the Revised Uniform Partnership Act (RUPA), so there is some uniformity in the United States in how partnerships work.
Partnerships have some tax advantages over other business entities. For instance, income or loss allocations or distributions must be proportional to the ownership interest of the shareholders of an S or C corporation, while a partnership may annually allocate income and cash flow among the partners that best suits the partners. Partnerships allow the pooling of resources, have simple filing requirements, avoid double taxation such as that on corporate profits, and it is relatively easy to discontinue operations. Partnerships can liquidate tax-free, whereas corporations are taxed at the entity level when they liquidate.
Limited partnerships are much like general partnerships except that a limited partnership has 1 or more general partners and 1 or more limited partners. General partners have full liability for all debts of the partnership, but the liability of limited partners is limited to their investment. In most states, limited partnerships must register with the Secretary of State or the Department of Corporations. If the limited partnership offers shares to the public, then it must also register with the Securities and Exchange Commission. Family owned businesses are often organized as family limited partnerships with certain tax advantages, especially in estate planning.
Other types of partnerships that limit personal liability include limited liability companies (LLC) and limited liability partnerships (LLP), where even the general partners enjoy limited liability. They are not liable for any judgments against the other partners, and creditors only have access to the assets of the LLC or LLP — the individual partners have no liability for the debts other than their LLC or LLP interest. LLCs can have 1 member, while LLPs must have at least 2 members.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, allows pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorship's and independent contractors to deduct 20% of their business income. However, this deduction starts to phase out for couples earning at least $321,400 or $160,700 for singles (adjusted annually for inflation).
This new business deduction, called the §199A deduction or the deduction for qualified business income, equals the lesser of:
- 20% of qualified business income + 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income, or
- 20% of taxable income − net capital gains
Unlike the changes for regular taxpayers, most of which expire in 2025, most of the tax changes for businesses have been made permanent.
The Legal Treatment Of A Partnership
A partnership can be viewed as an aggregate of partners or as a separate entity. As an aggregate (aka conduit), the partnership is treated as an aggregate of separate tax-paying partners, a channel through which income, deductions, credits, and other items flow to the partners (IRC §701), which they report on their individual returns. The partnership does not exist separately from the partners. As an entity, the partners and partnerships are treated as separate entities. For instance, both the partnership and the partners must file tax returns, and the partnership can choose a tax year that is different from the partners. So even though tax law often treats the partnership as a conduit, it also treats it as an entity in itself.
Exclusion from Being Treated as a Partnership for Federal Tax Purposes
Certain partnerships not conducting a business can choose to be completely or partially excluded from being treated as a partnership for federal tax purposes, if all partners agree to the choice and they are able to figure their own individual taxes without knowledge of the other participants' income.
Aside from the joint venture as an option for spouses, the most common partnerships that can choose not to be treated as a partnership include investment partnerships, where the participants buy, manage, and sell investment property, but only if:
- they co-own the property
- each partner can separately dispose of any shares acquired or retained; and
- they do not authorize another person to buy, sell, or exchange their investment property. However, each separate participant can delegate that authority, but not for longer than 1 year.
An operating agreement partnership can also be excluded from being treated as a partnership if:
- the participants extract or use property or engage in some other joint production
- they co-own the property or the operate under some contract granting them exclusive operating rights to the property, such as a lease
- the participants can individually manage or dispose of their shares of any produced, extracted, or used property; and
- they do not jointly sell the property or services. However, each separate participant can authorize someone else to sell their property for a limited duration that does not exceed the shorter of the minimum needs of the industry or 1 year.
An eligible organization can elect to be excluded from partnership tax requirements by indicating the desire in the partnership return for the 1st tax year for which the exclusion is desired, even if the filing date is extended.
Starting a Partnership
Partners can be individuals, trusts, estates, corporations, associations, or even another partnership. A partnership may also be classified as, or part of, a syndicate, group, pool, joint venture, or other unincorporated organization as long as the organization is not a corporation, trust, or estate. IRC §7701
A general partnership can be started by simple agreement — it does not even have to be a written agreement, although it should be, since it will prevent many problems. Without a written agreement, state law may determine the dispute.
When starting a partnership, initial decisions must be made in conducting the business, such as choosing methods of accounting and depreciation, whether to amortize startup costs, and choosing the tax year. Each partner contributes money, property, or services to the partnership, representing each partner's capital interest in the partnership and measured by the capital sharing ratio, which is the partners' percentage ownership of the initial capital. The total capital of the partnership = the net asset value of the partnership, the value remaining after all partnership liabilities have been paid.
Because the partnership is not a taxable entity, another ratio that must be established is called the distributive share, or the profit interest, which determines the allocation of profits, losses, and other tax related items to each partner. The distributive share is often proportional to the partner's capital interest, but the partnership agreement often provides for a different ratio because of differences in the hours worked by each partner and in the skills or connections that they bring to the partnership. The distributive share can be changed by amending the partnership agreement. A partner may also have only a profit interest because they did not invest any capital, but their interest is earned by working for the partnership — these partners are often called profits partners.
The partnership agreement can also provide a special allocation of some separately stated items, such as the interest from tax-free investments. So if a partner contributed tax-free municipal bonds to the partnership, the agreement could provide that the contributing partner receives all the interest from those bonds. However, special allocations must have some economic purpose other than altering tax liabilities for the partners. For instance, if a partnership earns tax-free interest and that interest is distributed preferentially to the partner in the highest tax bracket, then the IRS may reallocate the income so that it is distributed according to the distributive share.
Many tax items of a partnership that flow through to the partners are separately stated items because different partners may have limits on what they can deduct. For instance, charity contributions may be limited by the adjusted gross income of the partner. Another example where the items are separately stated is ordinary income and capital gains or losses because they are taxed differently and each partner may have other capital gains or losses that can be combined with the gains or losses from the partnership. What is not separately stated is netted out and divided among the partners according to their distributive share. Other items that are usually stated separately include dividend income, tax preferences and adjustments to the alternative minimum tax, any expenses that qualify for the foreign tax credit, and expenses that would be possible itemized deductions for the partners. Section 179 expenses are also reported separately, since there is a limit on what each partner can claim.
Partnership Capital Accounts
Partners can contribute money, assets, or services in exchange for their partnership interest. The value of the total contribution determines the partners' percentage ownership of the partnership and is recorded and updated continually in what is called the partners' capital account, which represents the equity of each partner in the partnership. The distributive shares of income accrue to the partners' capital account and losses are deducted from it. The total equity of a partnership is determined in the same way as stockholders' equity for a corporation:
Assets = Liabilities + Partners' Tax Capital Accounts
Partners' Tax Capital Accounts = Assets - Liabilities
The capital account balance = the tax basis of the partnership interest, which will change annually when the partnership earns income or suffers losses, and also because of withdrawals by the partners. So if a 50/50 partner has $20,000 in his capital account, and the partnership earns $30,000 for the year, then $15,000 is distributed equally to both partners, unless otherwise specified. So each partner will now have $35,000 in their capital account (assuming that the other partner also initially had $20,000). If a partner withdrawals $10,000, then he will have $25,000 in his capital account. However, the partners must pay taxes on their $15,000 share of income that was earned during the year, whether they withdraw it or not.
Any property contributed to the partnership increases the partner's interest by the value of the property. However, if the partner had debt on the property when it was transferred to the partnership, and the partnership assumes the liability, then the value of the property to the contributing partner = the property's fair market value + the portion of the liability that still applies to the contributing partner. So if a partner contributes land with a fair market value of $10,000 to a 50/50 partnership, where the contributing partner has a tax basis of $5000 and a mortgage of $4000 on the property, then the partner's capital interest is increased by the value of the contribution, which = $10,000 + 1/2 of the mortgage that the partner is still liable for, equaling a total of $12,000. No taxes are due on any gain until the property is sold or otherwise disposed of.
When a partner contributes services for a percentage of the profits, that amount is ordinary taxable income in the year the partner provided the services. This is a common situation where one partner has the money while the other partner has the expertise and time to operate the business. The assumption of a liability of the partnership by a partner is considered a contribution of capital in the amount of the liability.
However, if a person contributes services to receive a profits interest in the partnership, then the value of that interest is not taxable unless:
- the income is predictable;
- the partner disposes of the profits interest within 2 years of acquiring it; or
- the profits interest is a limited partnership interest in a publicly traded partnership.
The capital accounts serve as a record of the partners' tax basis in the partnership. The adjustment of basis prevents double taxation, which would result if the partners sold their interest in the partnership.
As a partnership operates, the partner’s basis in the partnership will change during the partner’s ownership, either increasing or decreasing (IRC §754). The partner’s basis increases by:
- contributions to the partnership or other forms of acquisition (e.g., purchases)
- the partner’s share of taxable and tax-exempt income from the partnership
- an increase in the partner’s share of partnership liabilities (including partnership liabilities assumed by the partner).
A partner’s basis decreased by:
- the partnership distributions of money or other property
- the partner’s share of partnership losses and non-deductible, non-capitalized expenditures, including the partner’s share of disallowed partnership losses if such losses reduce the basis of partnership assets without affecting its income
- a reduction in a partner’s allocable share of partnership liabilities, a reduction in a partner’s share of partnership debt treated as a cash advance to the partner. The decrease in basis occurs at yearend, not when the partner’s share of debt declines.
Partnerships may distribute money or property to the partners, which is usually not taxable, since earnings are taxed whether the income is distributed or not. However, if the partnership distribution exceeds the partner's tax basis in the partnership, which is generally known as the partner's outside basis, then the excess will be recognized as a capital gain. See Partnership Distributions for more information.
Partnership Tax Reporting
Partners must pay tax on the net income of the partnership, even if the partnership retains the income. Any amount that a partner does not withdraw increases that partner's basis; distributions decrease it. Therefore, distributions to partners per se are not taxed unless the distribution exceeds the partners' adjusted basis in the partnership, in which case, the excess is taxable; otherwise the draw is considered a return of capital.
A partnership — like limited liability companies and S corporations — are pass-through entities, where the profits and losses of the entity pass through to the owners. Nonetheless, the partnership must file a tax return, even if no tax is due.
A partnership must obtain a federal employer identification number (FEIN) from the IRS that uniquely identifies the partnership, just as a Social Security number uniquely identifies an individual taxpayer. Most states also use this number, although some may issue their own ID.
For tax years after 2017, certain partnerships must have a tax matters partner (TMP), who must be a general partner, The TMP is designed to replace the partnership representative.
A partnership must file Form 1065, U. S. Return Of Partnership Income for each year of its operation. Form 1065 is much like the Schedule C that sole proprietors use to report income. The tax return is due on the 15th day of the 4th month after the end of the partnership tax year. However, a partnership that only invests in property, but does not operate as a business, does not have to file Form 1065. A partnership can file Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns to request an automatic extension of 6 additional months to file a tax return. Most states tax partners but not partnerships. However, they do require filing of a form like Form 1065. Furthermore partnerships usually have to pay a franchise fee for the privilege of operating in the state.
Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. is an informational form sent by the partnership to the IRS and to each partner, showing each partner's portion of the income or loss, deductions, credits, and other allocated items from the partnership. Partners report the business income or loss on Schedule E, Supplemental Income and Loss and any interest or dividends are reported on Schedule B, Interest and Ordinary Dividends. Likewise, the partnership reports any capital gains or losses on Scheduled D, Capital Gains and Losses.
General partners, but not limited partners, must pay self-employment tax on their share of partnership profits. Partnerships with income must also pay estimated income taxes 4 times a year. For a calendar year partnership, the dates on which the estimated payments must be made are the same as those for sole proprietors: April 15, June 15, September 15, and January 15 of the following year. Form 1040-ES is used to report and pay estimated taxes. The federal payments cover both income and self-employment taxes. Estimated payments must also be made to the state.
If the partnership has a different tax year from the partners, then the partners must include partnership income or losses for the full partnership fiscal year that ends during the partner's tax year. So if a partnership's fiscal year ends on May 31, 2017, and the partners use a calendar tax year, then the partners must report the annual income of the partnership as of May 31, 2017 on their 2017 tax returns, even though 7 months of that income was earned in 2016. However, tax rules restrict the choice of tax year for a partnership to prevent the selection of a tax year for the primary purpose of deferring income.
Partnership expenses are deductible as they are for any other type of business if it is related to the trade or business that the partnership is engaged in. However, the expenses are shown on the partnership's tax return — Form 1065 — not on the individual partners' returns.
Starting in 2017, the Surface Transportation and Veterans Healthcare Choice Improvement Act of 2015 has modified some business filing dates:
- partnership returns must be filed by March 15, whereas previously they were due April 15;
- returns for C corporations are due in April 15, whereas previously, corporate file tax returns were due by March 15;
- employers are now required to file W-2 forms and 1099 forms with the IRS by January 31, whereas previously, the returns were due to the IRS by the end of February. In any case, these forms still must be mailed to the employee or independent contractor by January 31.
Partnership Representative (PR)
For partnerships with more than 100 partners and for partnerships that do not elect to opt out, the partnership must designate a Partnership Representative (PR) to represent the partnership before the IRS, especially for an audit. The PR, who does not have to be a partner, can be any person, entity, or even the partnership itself, and there can be no more than 1 PR. The PR must be designated on the partnership tax return for each taxable year. The PR must have a substantial presence in the United States, meaning that the entity or individual must have a US taxpayer identification number, a US street address and a telephone number with a US area code, and must be able to meet with the IRS at a reasonable time and place, in accordance with Treasury Regulation §301.7605-1.
Unlike the Tax Matters Partner (TMP), who often served as a liaison between the partnership and the IRS before 2018, and had limited authority to bind the partners, the partnership representative has the sole authority to act on behalf of the partnership during partnership audit procedures and can bind all the partners to any agreements between the PR and the IRS.
The partnership can opt out annually of using a PR, what is sometimes called the small partnership election, if the partnership has no more than 100 partners. The partnership must notify each partner of the election, and the IRS must then audit and assess tax to each partner.
The PR can be designated, changed, or revoked by using Form 8979, Partnership Representative Revocation, Designation and Resignation, but this form must be submitted in prescribed ways, which can be found in the Instructions for Form 8979, Partnership Representative Revocation, Designation, and Resignation Form.
Tax on the Value of the Partnership Interest
The capital accounts of the partners must be continually adjusted so that the proper amount of tax can be reported. If a partner contributes additional cash or properties to the partnership, then that partner's tax basis increases by the amount of the contribution. Capital accounts are not affected by partnership debts, since if the partnership takes out a loan, then the proceeds are considered an asset offset by the liability of the debt. When a partner contributes property, there may be a realized gain or loss on the property to the partnership. However, both gains and losses are deferred by IRC §721 until the partnership is liquidated or the partner sells her share of the partnership interest.
Partnerships are rarely audited by the IRS, because the partnership does not pay taxes directly — only the partners do. However, if the IRS does decide to audit the partnership or any of the partners, there is a good chance that all the partners will be audited.
Transferring or Terminating a Partnership Interest
If a partnership interest is sold to another partner, then that has no tax implications for the partnership. However, the selling partner will most likely have a taxable gain or loss, which is determined by subtracting the selling partner's tax basis in the partnership from the sale proceeds of the partnership interest. If the partner held the partnership interest for longer than 1 year, then the gain is subject to the long-term capital gains rate. However, if the partnership has hot assets, then some of the gain or loss may be ordinary. The sale must be reported to the IRS on Form 8308, Report of the Sale or Exchange of Certain Partnership Interests, which is filed with the partnership tax return.
If the partnership itself buys a partner's interest, then it is the same as selling to every partner in the partnership, which is referred to in the tax code as a retirement of the partner. For the retiring partner, the partner's capital interest is 1st subtracted from the proceeds to determine taxable income. If the partner's tax basis exceeds the sales proceeds, then the partner can deduct it as a loss on her investment. If the retiring partner is relieved of any debt of the partnership, then her portion of the debt is treated as income for the retiring partner.
If a partnership interest is sold before the end of the partnership's tax year, then the retiring partner must pay ordinary income tax on her share of the profits earned during the current tax year until the date of the sale. Any gain or loss on the partner's tax basis in the partnership is treated as a capital gain or loss.
A partnership automatically ends upon the death or withdrawal of a partner, unless the partnership agreement provides otherwise. All of the property of the partnership is then considered distributed equally to all the partners including the deceased or retiring partner. The partners will therefore have a gain or loss equal to the value of the property received minus the partners' tax basis in the partnership. A deceased partner's assets become part of his estate.
Terminating a Partnership
Under §1.708 - 1(b), a partnership is terminated when no part of the business is continued by any of the partners. It will also be considered terminated if at least 50% of the interest in the partnership's capital and profits is sold or exchanged within 1 year, even if it is a sale or exchange to another partner. However, this last provision does not apply to partnerships that elected to be a large partnership under the tax code. The date of the termination is when the business is completely stopped, or when the sale or exchange of a partnership interest, that, when added to previous sales or exchanges within the previous 12-month period, reaches at least 50%.
Often, the partnership will be terminated before the end of its tax year, resulting in a short tax year, when the end of that tax year is through to the date of termination. For 2015, the final return will be due by the 15th day of the 4th month after termination. However, for 2016 and onward, the return will be due the 15th day of the 3rd month after termination.
Converting to a Limited Liability Company
Converting a partnership into an LLC does not terminate the partnership, the tax year does not close, and the LLC can continue to use the taxpayer identification number of the partnership. The only adjustment that may be necessary is if the partnership had recourse debt that became nonrecourse debt. In this case, the partners' bases must be adjusted to the new sharing ratios. However, if a partner's share of liabilities decreases below the partner's basis, the amount that exceeds the basis must be recognized as gain.