Is This Your Situation: Having Trouble Understanding Partnership Taxation

Partnerships fall into a category known as “pass-through entities” by the Internal Revenue Service (IRS). They are not considered to be separate from their owners. All profits and losses pass through the business directly to the partners and each pays taxes on his or her share of the profits or deducts his or her share of the losses on individual income tax returns. The portion paid will depend on the agreement between the partners.

Distributive Shares

According to the IRS rule about distributive shares, even if partners need to leave profits in the partnership for the purpose of covering future expenses or expanding the business, each partner still will owe income tax on his or her rightful share of that money.

Each partner should set aside enough money to pay taxes on his or her share of annual profit because there’s no employer to withhold income taxes. Like many small business owners or independent contractors, partners must estimate the amount of tax owed for the year and make quarterly payments to the IRS and the appropriate state tax agency.

Self-Employment Taxes

But things become slightly more complicated when considering the requirements for Social Security and Medicare programs. Much like the payroll taxes that employees pay, self-employment taxes are required on all partnership profits. There are ways for partners to deduct half of their self-employment tax contribution from their taxable income, which could lower the tax bite.

It’s important to know that there is no way around this when you enter into a partnership. Even without a partnership agreement, partners are still bound by state law. Partners must pay taxes on their share of the partnership’s profits, which is made up of total sales minus expenses, regardless of how much money actually is withdrawn from the business.

Business Expenses

But don’t worry, there is good news. Partners don’t need to pay taxes on most of the money the business spends on legitimate business expenses, which will be deducted from your business income. This can lower the profits you have to report to the IRS. Expenses such as start-up costs, travel outlays (including meals and entertainment), operating expenses, and product and advertising spending are acceptable.

It gets more complicated when trying to figure out which forms should be filed quarterly and at tax time each year. Because you don’t need to be a tax accounting specialist, we highly recommend working with an expert to navigate this experience so you and your partner can focus on practicing law. Contact us today to learn more.