Structuring a Business Partnership: Understanding Your Tax Obligations
A business partnership does not pay taxes on income. The partnership is a pass-through entity and the individual partners pay tax on their distributive share of partnership income passed through to them. Each year, the partnership files a return, Form 1065, to report to the IRS the income, gains, losses, deductions, and credits from the business, Weltman says. It also files a Schedule K-1 for each partner, allocating a share of each item of income, deductions, etc. according to the terms of the partnership agreement. Similar reporting may be required at the state level.
Each partner reports his or her share of income on Schedule C of his or her personal income tax Form 1040. If the partnership is profitable, each partner must pay self-employment taxes on his or her net earnings. These taxes cover the employer and employee share of Social Security and Medicare taxes. Because a partner is not an employee (a partner is a self-employed person), there is no withholding from a paycheck to cover income and self-employment taxes. Instead, these taxes are paid through quarterly estimated tax payments.
There are special rule for husband-wife ventures. If a married couple operates a venture in which each materially participates and they file a joint return, they can opt not to file Form 1065. Instead, they can file a single Schedule C (the form used by sole proprietors) to report their share of business income and expenses.
Dig Deeper: How to Reduce Your Small Business Tax Bill
Structuring a Business Partnership: Other Details
Weltman says to make sure to deal with various other business matters before your partnership begins operations:
- Obtain a federal employer identification number. A new partnership must obtain a federal employer identification number (EIN). This can be done instantaneously and at no cost from the IRS. When partners exit the partnership, or new partners are added, your partnership may need to obtain a new EIN as it is considered a "new" partnership for tax purposes.
- Obtain licenses and permits. Depending on your type of business, the partnership and/or each partner may be required to have a license or permit to operate legally.
- Choose a location. Decide the "official" address for the partnership. With technology enabling partners to work from remote locations, it is helpful to designate one place to receive partnership mail. If partners operate from their respective homes, the partnership can obtain an address from such companies as a UPS Store or a virtual office.
- Obtain insurance. Because each partner's personal assets are exposed to the claims of the partnership's creditors, the best way to obtain protection is to carry adequate insurance for the unexpected. Discuss these and other types of coverage with an insurance agent: property and liability coverage, auto insurance, and health coverage.
Structuring a Business Partnership: Writing the Partnership Agreement
General partnerships can be informal, oral arrangements to share profits and losses of a business venture. However, it is highly advisable to use a formal, written partnership agreement to spell out how income, deductions, gains, losses, and credits are to be split. If the agreement is silent, then state law is used to fill in gaps -- and that could leave a lot of decisions up to the courts if you and your partner(s) have a falling out.
"Legally, you're not required to have a written partnership agreement but I think you're a fool not to have one," Ennico says. "If you don't have a written agreement, a judge looks at the partnership statute and that acts as your agreement."
That may be fine. But it may also not be so good, Ennico says, because the partnership laws in many states assume that all partners are equal. "If we set up a partnership on a handshake and agree to split the business 70-30, and we then have a falling out because you think you are working harder than I am and deserve a bigger share of the profits, the law may say we are 50-50 partners unless we can clearly document in writing, for example a signed Form 1065, our intent to create an unequal split," Ennico says.
Laws vary by state. There are sample partnership agreements available on legal websites on the Internet, such as Law Depot and LegalZoom. But a partnership agreement can be put in writing by a lawyer for between $500 to $1,000 and that might very well be worth the investment to your business, Ennico says. "Never undertake a partnership agreement without an attorney," he says. "I once handled an agreement involving a 20-member engineering firm that consisted of 90 pages plus schedules. It took more than six months for the partners to reach agreement on all the details."
Here are some critical elements to include in a partnership agreement:
1. Partnership information.
• List the name of the partnership, location, when it was formed and the purpose of the business.
• Who the partners are and their capital contributions
• Determine who the partners are and list them, their addresses, and Social Security Numbers. Then detail what the partners are putting into the partnership. These contributions may include money, intellectual property, customers, machinery, vehicles, etc.
