When working with clients, I often see confusion when it comes to understanding how taxes work in business partnerships. If you’re starting or growing a business with someone else, it’s important to understand what having a partnership means for your business and for your taxes. In today’s post, I’ll explain the types of partnerships you can form and how each type is taxed so that you can go into this relationship with your eyes wide open.
What is a business partnership?
Maybe this seems like a silly question, but if you’re looking to start with a basic definition, it’s this: A business partnership is a business owned by 2 or more people who agree to share profits, losses, and responsibilities.
At the federal level, almost all partnerships are considered pass-through entities, meaning:
- The partnership itself generally does not pay income tax.
- Instead, profits and losses “pass through” to the partners.
- Each partner then reports their share on their personal tax return.
Even if you never sign a formal agreement with your business partner, if you’re running a business together and sharing profits, then you technically already have a partnership.
The are also several partnership business structures that you can choose from and that I’ll explain in this post:
- General Partnership
- Limited Partnership
- Limited Liability Company Partnership
- Partnership with S-Corporation Status
What is a general partnership (GP)?
A general partnership (GP) is the simplest form of partnership. In it:
- All partners manage the business,
- All partners share profits and losses, and
- All partners have unlimited personal liability.
How is a general partnership taxed?
General partnerships file an informational return using Form 1065. Then, each partner receives a Schedule K-1 from the business that shows their share of profits, losses, deductions, and credits. Finally, each partner reports that information on their personal income tax return.
For example, let’s say 2 partners open a design studio, the business makes a $200,000 profit, and the partners split the profits 50/50. This means that each partner would report $100,000 of income on their personal return even if the business didn’t distribute that money to the partners.
An important note here is that in a general partnership, all partners usually pay self-employment tax (Social Security and Medicare taxes) on their share of the business income.
What is a limited partnership (LP)?
A limited partnership (LP) has two types of partners:
- General partners who manage the business and have unlimited liability, and
- Limited partners who invest money but do not manage the day-to-day operations of the business.
A limited partnership is common in real estate ventures (think AirBnB) or similar situations where one or more partners is an investor but doesn’t have management control over the business.
However, there is a difference between a limited partner and a run-of-the-mill investor. The difference comes from the fact that a limited partnership is legally structured so that the limited partner(s) must have a completely passive (not in control) role in the business in return for liability protection of their personal assets.
How is a limited partnership taxed?
Just like a general partnership, in a limited partnership, the business files Form 1065, each partner receives a Schedule K-1 from the business, and the income passes through to the partners who pay income tax on their individual income tax returns.
The two key differences between a general partnership and a limited partnership are that in a limited partnership, the limited partners:
- Have liability protection, and
- Have different self-employment tax treatment.
Here’s the important piece to keep in mind about taxes: In limited partnerships, general partners usually pay self-employment tax, but limited partners typically do not pay self-employment tax because they only have passive income from the business. However, limited partners do need to pay self-employment tax on any guaranteed payments.
What is a guaranteed payment in a partnership?
A guaranteed payment is money paid to a partner for services or capital, and it’s not tied to profitability. Many people think of a guaranteed payment like a salary.
Guaranteed payments are deductible by the partnership, taxable by the receiving partner, and usually subject to self-employment tax.
What is a limited liability company (LLC) partnership?
This is where many small business owners can get confused. A limited liability company (LLC), which is sometimes called a limited liability partnership (LLP) is a legal structure and not a tax classification.
If an LLC has 2 or more members and isn’t being taxed as a corporation, then it’s taxed as a partnership by default (just like if it was a general partnership). Since it’s taxed the same, the business still files Form 1065 and issues Schedule K-1s to the partners, but in LLCs, all partners also get liability protection.
Can a partnership or LLC partnership elect S-Corporation taxation?
Yes, a partnership or LLC partnership can elect to be taxed as an S-Corporation by filing IRS Form 2553.
Why would a partnership elect to be taxed as an S-Corporation?
In a regular partnership, all active members usually pay self-employment tax. However, if the partnership has elected to be taxed as an S-Corporation, then the owners can pay themselves a reasonable salary (subject to payroll tax) and can also pay themselves distributions that aren’t subject to self-employment tax.
This strategy can greatly reduce your overall tax bill!
One thing to note is that depending on your situation, electing S-Corporation status can lead to more payroll and compliance complexity, but the lower tax bill often outweighs those inconveniences. You should work with an account to run the numbers and help you correctly set up your S-Corporation if you’re thinking of taking advantage of this strategy.
How are profits and losses split in a partnership?
Many small business owners assume profits must be split 50/50, but that’s not true.
The way you allocate profits is defined by your partnership agreement, which is a written contract that outlines:
- Each partner’s roles, responsibilities, and decision-making power
- Capital contributions
- Profit and loss sharing
- Financial accounts
- Salaries, distributions, and draws
- Dispute resolution
- Exit or dissolution plan
- How new partners will be handled
If you’re looking for more details about partnership agreements or a free template you can use to make one for your partnership, I recently wrote a blog post and included a free template that does just that.
Do partners pay taxes even if they don’t take distributions?
Yes, even if the money stays in the business, any business profit is taxable income for the partners. This is why it’s smart to plan for tax distributions. These are cash payouts to the partners made specifically so the partners can cover their personal tax liability (aka pay their tax bill).
What taxes do small business partners need to pay?
In addition to income and self-employment tax, partnerships may also have to pay:
- State income tax
- Payroll tax (if there are employees)
- Sales tax (if selling goods or services)
- Franchise or gross receipts tax (in certain states)
It’s important to check in with a certified public account (CPA) to understand the full picture of which taxes need to be paid in your particular situation.
What are common partnership mistakes made by small business owners?
The common mistakes I see partnerships make are:
- Not creating a partnership agreement
- Not planning for tax distributions
- Ignoring self-employment tax
- Mixing personal and business finances
- Failing to discuss exits and future buy-outs ahead of time
Something to keep in mind when entering into a partnership is that taxes are manageable, but relationships often cause issues and friction. Communicating early and clearly (just like in any relationship) can help you and your partner(s) avoid problems that will likely arise.
Should I have a small business partnership?
Deciding if a business partnership is right for you and your business is a big decision. Some questions to ask yourself are:
- Do we have the same long-term vision for the business?
- How will we handle profits, losses, and taxes?
- What roles and responsibilities will each of us have?
- What happens if one of us wants out of the business?
- Do we trust each other with debt, taxes, and legal risks?
Abridged by Amy
Entering into a business partnership can be a great way to combine skills, share responsibilities, and grow a business faster than you might on your own. But choosing the right business structure is almost as important as choosing the right business partner.
Ideally, you’d think through these decisions, including how your income will be taxed, before starting your business. In reality, that doesn’t always happen, and that’s okay! Any time is a good time to review your setup and make sure your business decisions are tax-efficient.
If you’d like help talking it through or running the numbers for your specific situation, consulting a CPA can give you confidence in your decisions and highlight any changes that might improve your tax position.
P.S. If you’re looking to hire your spouse (like I did!), then don’t miss my post that explains all of the tax advantages you can gain by going this route.
