written by: Sandi Johnson•edited by: Wendy Finn•updated: 1/8/2011
Partnerships provide the ability to pass through income to owners, without the organization paying taxes on company income. However, understanding partnership tax laws requires more than just knowing about pass through entities. Not paying taxes does not mean you don’t file taxes.
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Two Partnerships, One Tax Law
Understanding partnership tax laws begins by understanding how the law is applied to different entities. In terms of legal entities, there are two ways to form a partnership. A general partnership is similar to a sole proprietorship, in that there are no state charter requirements. Two individuals simply agree to do business together, draft a partnership agreement, and the business is born.
Alternatively, a limited liability partnership (LLP) is formed through charter by the Secretary of State in which the partnership resides; laws governing the formation of such partnerships varies from state to state. One limited liability partnership benefit, is that it protects partners by limiting their liability for negligence and organizational debt to an amount equal to their investment in the partnership.
However, in the eyes of the IRS, one partnership is the same as the other. The same tax laws govern both types of partnerships. The two distinctions are more to protect owners from liability and personal financial harm, than any form of tax benefit.
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Pass Through Taxation
As a partnership, whether general or limited liability, the organization is subject to pass through taxation. In short, this means that rather than the company paying tax on income as a business entity, the owners or partners pay taxes on profits as personal income - this is similar to sole proprietorships, S Corporations, and Limited Liability Corporations. The pass through taxation applies to both federal and state taxes. Owners receive a K-1 statement that indicates their portion of taxable business income. This statement is similar to a W-2 for an employee, or a 1099 for an independent contractor.
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Understanding Partnership Tax Laws for Filing Business Taxes
One particular tax obligation for partnerships, presents difficulty for novices when it comes to understanding partnership tax laws. Partnerships are obligated to file tax returns and claim deductions for business expenses. The organization does not have to pay taxes with this return, but rather report income totals, after allowable business deductions. The return reports the entire organization's income, and allows the determination of each partner’s share of said income. The IRS requires partnerships to use Form 1065 to report the organization's income.
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Tax Laws for Individual Partners
After the partnership prepares their Form 1065, individual partners are issued Schedule K-1s for their portion of the organization’s income. The resulting figures are derived after all business expenses are deducted. In accounting, this income is considered an owner’s draw, so it is neither expensed by the business, nor taxed as payroll. Therefore, the partnership’s organizational return merely deducts standard business expenses, and distributes earnings to partners according to the partnership agreement. The Schedule K-1 is then included with each owners’ individual tax return. Since this income is neither taxed, nor classified as salary or wages, partners are considered by the IRS to be self-employed, and must pay self-employment taxes on partnership income accordingly.
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References and Resources
Horngren, C, Harrison, W, & Smith, L. (2005). Accounting. Upper Saddle River, NJ: Pearson Education.