Making Sense of Partnerships and Taxes

Author: NCH Internal Editorial Team
Reviewed by Cort W. Christie, MBA
Cort W. Christie, MBA is the Founder of Nevada Corporate Headquarters (NCH) and a nationally recognized entrepreneur, executive, author, and speaker. Mr. Christie has spent over 32 years helping business owners structure, protect, and scale their companies.

This article has been reviewed by Mr. Christie to ensure accuracy and value for today’s entrepreneurs. Jump to...

Partnerships, as business entities like LLCs, have distinct tax considerations compared to corporations or sole proprietorships. Unlike C-corporations that face double taxation—where both the company and shareholders are taxed—partnerships benefit from pass-through taxation.

The Basics of Pass-Through Taxation

In this system, the partnership itself is not taxed at the entity level. Instead, income, deductions, credits, and other tax items pass through to the individual partners, who report these items on their personal tax returns. This ensures that partnership earnings are only taxed once at the individual partner's rate, potentially leading to significant tax savings.

Each partner receives a Schedule K-1 (Form 1065). This information is then transferred to the partners' individual tax returns. The allocation of income and losses is usually based on the partnership agreement specifying each partner’s share.

Forming a Partnership for Tax Purposes

A partnership is created when two or more individuals agree to carry on a trade or business and share the profits and losses. The agreement can be written, oral, or implied, depending on the behavior and actions of the parties involved.

The formation of a partnership also requires obtaining an Employer Identification Number (EIN) and creating a partnership agreement. The latter details the profit and loss sharing arrangements, management roles, and other important aspects of the business.

Types of Partnerships

• General Partnerships (GPs): Involves two or more partners with equal responsibility and liability. GPs do not pay income tax at the entity level and are taxed on their share of the partnership income, regardless of whether they actually receive a distribution.
• Limited Partnerships (LPs): Consists of at least one general partner and one or more limited partners. The partnership itself does not pay taxes; income, deductions, credits, and other items pass through to the partners based on their ownership percentages.
• Limited Liability Partnerships (LLPs): Offers liability protection to all partners to prevent debts or claims against the partnership. Like GPs and LPs, LLPs do not pay federal income tax and self-employment taxes on their shares at an entity level.

Partnership Profits and Losses

As mentioned earlier, partnership agreements specify how profits and losses are to be allocated among partners. These allocations must comply with the IRS’ substantial economic effect rules and reflect the partners’ interests in the partnership.

Accurate record-keeping is critical for partnerships. Detailed records ensure that profits and losses are correctly allocated and reported, facilitating the accurate preparation of tax returns. These records also support the partnership’s tax positions in the event of an IRS audit.

Partner Tax Reporting Responsibilities

Every year, partnerships must file Form 1065, U.S. Return of Partnership Income, and provide each partner with a Schedule K-1. The K-1 details the partner’s share of the partnership’s income, deductions, credits, and other tax items. Partners use the information on the K-1 to complete their individual tax returns.

Form 1065 needs to be filed by the 15th day of the third month following the end of the partnership's tax year, typically March 15 for calendar-year partnerships. Individual partners must report the K-1 information on their tax returns due April 15.

Self-Employment Taxes

Those in a partnership are considered self-employed, which means the partners must pay self-employment taxes on their share of partnership income. This includes Social Security and Medicare contributions, which are reported on Schedule SE.

Self-employment taxes are calculated using Schedule SE, Self-Employment Tax, and reported on the partner’s Form 1040. The current rate for self-employment tax is 15.3%, comprising 12.4% for Social Security and 2.9% for Medicare. Partners can deduct the employer-equivalent portion of the self-employment tax (50%) when calculating their adjusted gross income.

Deductions and Tax Credits

Partners can benefit from various deductions and tax credits. These include business expenses, such as office supplies, travel, and meals. Partners may also be eligible for tax credits, such as the Research and Development (R&D) Credit or the Work Opportunity Credit.

Meanwhile, deductible business expenses include those that are ordinary and necessary for conducting the partnership’s trade or business. These can range from rent, utilities, and salaries to advertising, professional fees, and insurance premiums.

Estimated Tax Payments

If you or a partner expects to owe at least $1,000 in tax after subtracting withholding and refundable credits, you must make quarterly estimated tax payments. These payments help manage cash flow and avoid significant tax liabilities at year-end. The IRS requires estimated tax payments in the following year in April, June, September, and January.

Failing to make estimated tax payments can result in underpayment penalties. Partners can avoid these penalties by paying at least 90% of the tax for the current year or 100% of the tax shown on the previous year’s return, whichever is smaller. Using IRS Form 1040-ES, Estimated Tax for Individuals, can help partners calculate and make these payments.

Partnership Losses and At-Risk Rules

Although a share of partnership losses on the partner's tax returns can be deducted, certain limitations apply. The deductibility of these losses is subject to the at-risk rules, which limit loss deductions to the amount the partner has at risk in the partnership.

The at-risk amount includes the partner’s cash contributions, the adjusted basis of property contributed, and amounts borrowed for use in the activity for which the partner is personally liable. Losses exceeding the at-risk amount are carried forward and can be deducted in future years when the at-risk amount increases over time.

Partnership Tax Elections

One way to optimize a partnership's tax situation is by making a Section 754 election, which allows for an adjustment to the basis of partnership property when a partner’s interest is transferred or when there is a distribution of property.

Remember that the Section 754 election can have substantial tax implications, impacting the calculation of depreciation, gain or loss on the sale of partnership property and the partners’ outside basis. Making this election requires careful consideration, and once made, it is binding for the partnership and can only be revoked with IRS consent.

State and Local Tax Considerations

It is imperative for partnerships and partners to understand and fulfill state and local tax obligations, which can vary significantly by jurisdiction. Some states impose entity-level taxes on partnerships, while others follow the federal pass-through taxation model.

For partnerships in multiple states, nexus and apportionment rules determine how income is divided among the states. Nexus is the connection partnerships have with a state, while apportionment involves dividing income based on sales, payroll, and property within each state.

Changes in Partnership Tax Law

Recent tax reforms have introduced changes impacting partnership taxation. The Tax Cuts and Jobs Act (TCJA) has brought significant modifications to partnership taxation, including the introduction of the Qualified Business Income (QBI) deduction for pass-through entities.

The TCJA’s changes have impacted how partnerships plan and report taxes. For instance, the QBI deduction allows eligible partners to deduct up to 20% of their qualified business income, subject to certain limitations and thresholds.

Tax Planning Strategies for Partnerships

Effective tax planning involves strategies to minimize tax liabilities while complying with tax laws.

• Maximize Deductions and Credits: Ensure you claim all eligible deductions, such as mortgage interest, charitable donations, and medical expenses. Take advantage of tax credits like the Earned Income Tax Credit (EITC) and Child Tax Credit.
• Utilize Tax-Advantaged Accounts: Contribute to retirement accounts (401(k), IRA) and health savings accounts (HSA). These contributions often reduce taxable income.
• Timing: Timing income and expenses can impact your tax bracket. Deferring income to the next tax year or accelerating deductible expenses can lower current liabilities.
• Tax-Loss Harvesting: Offset capital gains with capital losses by selling underperforming investments. This strategy can reduce taxable investment income.
• Plan for Major Life Events: Events like marriage, having children, or buying a home can significantly affect your tax situation. Adjust your tax planning accordingly.
• Stay Informed: Tax laws change frequently. Stay updated on tax regulations and consult a tax expert to ensure you take advantage of all available tax-saving opportunities.

Final Thoughts

Understanding partnership taxation is a must for partners to ensure compliance and optimize their tax situation. Each aspect requires careful attention and planning, from pass-through taxation to state and local tax considerations. Proactive tax planning and working with professionals can minimize tax liabilities and ensure the financial health of the partnership.

At NCH, we are committed to helping you navigate the complexities of partnership taxation. From formation to ongoing compliance and tax planning, our experts provide personalized support to ensure you maximize tax benefits while meeting legal obligations.

Check out our website or call 1-800-508-1729 to consult one of our tax professionals today!

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.

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