When deciding on the business form of your new company, it is important to consider tax requirements, which can differ substantially among the various types of businesses. One of the options frequently taken by small businesses is forming a partnership. If your company will have two owners or more and you decide that incorporating is not the best choice, a partnership may be suitable for your business purposes.If you are considering forming a partnership, you should be aware of the tax consequences. Since a partnership is not incorporated, it does not become an independent entity when it comes to taxes. As a result, the partners are taxed individually for the profits that accrue to them from the partnership. As a partner, you should be cognizant of the partnership losses, profits and expenses you will be required to report on when filing your personal taxes.
Profits and Losses
You will be taxed individually on your share of the profits, but the actual reporting of partnership profits and losses is made by the company. This involves submitting two documents to the IRS: Form 1065, which itemizes losses and profits, and Form K-1, which details the ways in which losses or profits are distributed among the partners in order to let the IRS know how much each partner should be taxed. Business owners should remember that, just as with personal taxes, it is prudent to estimate and set aside a sum of money to cover the amount you will owe as a partner. When forming a partnership, do not neglect to draw up a partnership agreement that states clearly how profits and losses will be shared among the partners. A clear distribution will help avoid misunderstandings about taxes as well as disputes among partners. The percentage allotted to each partner is known as his or her distributive share. Whether or not you actually receive that percentage in a particular year or decide to leave some of it with the partnership, you will be taxed on the share specified in the agreement. If there is no formal agreement or no provision for distribution, you will be taxed based on the assumption of an equal distribution among the partners. For example, if there are two partners without an agreement, each will be taxed on half of the total profits and losses.
There may come a time when you and your partners decide to deviate from your distribution provisions or to distribute unequal shares in the absence of an agreement. This is known as a special allocation, which is legal and will be acknowledged by the IRS, but only if it was based on a substantial business reason. For example, one partner contributed to the partnership in a way that went above and beyond, leading the company to decide that he or she should receive a greater share than usual. However, when claiming a special allocation, you run the risk that the IRS will disagree with your assessment of the situation and decide that you alone made the change in order to game the tax system. In this case, you will be taxed based on your company’s usual distribution provisions. Claiming a special allocation is often complicated and should be done under the guidance of a qualified tax professional.
In addition to the major issues of profit and loss distribution, partners should be aware of other ways their taxes are affected by their partnership status. Deemed self-employed by the IRS, partners should be filing a Form 1040 with a Schedule SE. They are also responsible for the entirety of Social Security and Medicare contributions. As the chief business forms used by small companies today, partnerships and corporations each have their own pros and cons in terms of taxation. Learning about the basics of applicable tax principles can help you decide which is best for you as you start your new business. Be sure to consult a professional about specific situations and get more details about relevant tax issues.
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