Everything You Need To Know About How Partnerships Are Taxed

Partnership Tax Filing & Deadlines | Self-Employed Taxes | Estimated Taxes | How to fill out Form 1065

The most significant tax difference between LLCs and S corporations is the treatment of self-employment taxes. In an LLC, each member’s share of profit is subject to self-employment tax.

In an S corporation, each shareholder’s share of profit is NOT subject to self-employment tax. The IRS does, however, require S corporations to pay shareholders who contribute substantial services a “reasonable” salary. This salary is subject to payroll taxes.

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Similar to S corporations, LLCs (and partnerships) are considered “pass-through” entities where a business’s income and expenses flow through to the partners and are reported on the partners’ personal income tax returns.

A General Partnership

If you start a business with at least one other person and don’t incorporate, by default your business is a general partnership.

A general partnership is easy to start, does not require filing any paperwork with your particular state, and doesn’t require certain compliance activities such as recording minutes of meetings. Each partner can also deduct their share of business expenses on their individual tax return.

Another advantage of forming a business as a general partnership is flexibility when drafting partnership agreements. While profits of an S-Corporation must be allocated pro-rata, a general partnership can allocate a non-proportional amount of income (or expenses) to a specific partner or partners.

The biggest drawback of a general partnership is the absence of liability protection. Each partner of the business is personally liable for the business’s debts and other liabilities. In some states, each partner may also be personally liable for one of their fellow partner’s negligent actions.

As a general partnership begins to grow, it may also become difficult to qualify for a business loan, attract significant clients and build a credit history.

A general partnership may make sense to quickly get a business off the ground. Then, after a period of time, the general partnership can incorporate into either a C-Corporation or a Limited Liability Company.

Here are several other significant areas of LLC taxation:

  • State Taxation – Partners need to be aware that some states require LLCs to withhold taxes on behalf of the partners. This withholding is oftentimes mandated using the state’s highest marginal rate.

     

  • Partnership Audit Rules – Legislation in 2015 instituted new procedures for federal audits of partnerships. Audits will now be conducted, and any additional taxes will be levied, at the partnership level. Partnerships and LLCs have the option to elect out of these new audit rules. Under the old rules, the IRS would be forced to collect any additional taxes levied from the partnership’s partners, not the partnership itself. This election to opt-out of the new audit rules must be made annually.

     

  • Special Allocations – Another tax-related advantage that partnerships have over S corporations is being able to implement special allocations. As an example, let’s consider an LLC that has four members, each of whom owns 25% of the LLC. The LLC isn’t required to allocate 25% of the LLC’s profits and losses to each member. If agreed on by all the members and documented in the operating agreement, one of the members can be allocated 50% of the LLC’s profits and losses while the other three members split the remaining 50%. There are guidelines and limitations for how an LLC can structure special allocations. Please consult your tax advisor for more information.

     

  • Complicated Annual Reporting – While special allocations are what has partially made LLCs a popular business entity, special allocations can also cause tax compliance to become expensive and time-consuming for the LLC itself and its members. Complex tax consequences shouldn’t deter you from at least considering the LLC structure for your business with your team of advisers. The benefits of having an LLC may be greater than the time and money resources required to comply with state and federal tax laws.

     

  • Flexibility – An LLC always has the option of choosing to be taxed as an S corporation instead of a partnership. The LLC files Form 2553 with the IRS to make the election to be taxed as an S corporation. This is the same form used by a C corporation that elects to be taxed as an S corporation.

Self-Employment Taxes

Most partners and members of an LLC also pay self-employment taxes (SE taxes).

How is SE taxes different than income taxes? SE taxes are specifically earmarked to pay for Social Security and Medicare, so you’ll sometimes hear “SE taxes” also referred to as Social Security taxes or Medicare taxes.

For partners and LLC members, the SE tax rate is between 14% and 15%.

(If you’d really like to know why we said “approximate,” we’d be happy to elaborate!).

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Does a partner or LLC member need to pay quarterly taxes?

Does a Partner or LLC member need to pay quarterly taxes?

A partner or LLC member is generally required to make estimated tax payments, as taxes must be paid as you earn or receive income throughout the year, either through withholding or estimated tax payments. Estimated tax payments are used to pay not only income tax, but also other taxes such as self-employment tax and alternative minimum tax.

Deadline to pay your estimated taxes

For estimated tax purposes, your tax year is divided in four payments periods:

  • 1st Payment Deadline – April 18th – Covers income earned from January 1 to March 31
  • 2nd Payment Deadline – June 15th – Covers income earned from April 1 to May 31
  • 3rd Payment Deadline – September 15th – Covers income earned from June 1 to August 31
  • 4th Payment Deadline – January 15th – Covers income earned from September 1 to December 31

NOTE: If the payment deadline falls on a weekend or legal holiday (i.e. Martin Luther King, Jr. Day in January and Washington D.C.’s Emancipation Day in April), you may wait until the following business day to mail or submit your payment.

How to calculate your estimated taxes​

Here are some suggestions for figuring out how much your estimated tax should be.

  • A good starting point is to use your income, deductions, and credits on your prior year tax return.
  • Next, estimate your expected adjusted gross income, taxable income, taxes, deductions, and credit for the entire tax year.
  • Use the worksheet provided by the IRS in the instructions to Form 1040-ES or call our office for assistance.

If you subsequently discover that your estimate was too high, simply complete another Form 1040-ES worksheet to recalculate your estimated tax when it comes time for your next payment. If your estimate was too low, complete another Form 1040-ES worksheet to adjust your next payment.

How to pay your estimated taxes​

You can send estimated tax payments with Form 1040-ES by mail, or you can pay online, by phone or from your mobile device using the IRS2Go app. You can pay your estimated taxes weekly, bi-weekly, monthly, etc. as long as you’ve paid enough in by the end of the quarter.

Avoid paying a penalty!

If you don’t pay enough tax through withholding and estimated tax payments, you may be charged a penalty and/or interest. You may also be charged with a penalty if your estimated tax payments are late, even if you are due a refund when you file your tax return.

Partnership Tax Filing

A partnership or LLC files its tax return on Form 1065. Each partner receives a Form K-1 from the partnership. K-1s report each shareholder’s allocation of income, losses and other financial information from the business. The shareholder includes Form K-1 information on their individual tax return.

This section discusses filing a partnership tax return and the associated Form K-1s. If you have a partnership or LLC, please contact our office with any questions about how to file a Form 1065 or how to report a Form K-1 on your individual tax return.

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How to fill out Form 1065

  • Keep your accounting records and financial statements up-to-date. An accurate balance sheet and income statement helps to make preparing your partnership tax return extremely easy every year, and will ensure that you don’t run the risk of reporting to much (or too little) income. If your business grows big enough, you’ll be required to report your balance sheet on Schedule L of your partnership’s tax return.
  • Record your income. The first section of Form 1065 is where your business’s income and cost of goods sold is recorded.
  • Record your expenses. The second section of Form 1065 is where your business’s expenses are recorded.
  • Calculate your net profit or loss. Subtract your total expenses from your total income to compute your ordinary business income or loss. On a partnership tax return, the technical name for your business’s profit or loss is “ordinary income or loss”.
  • Record taxes owed and payments made. The vast majority of partnerships do not owe taxes at the business entity level. As discussed before, partners normally pay taxes on their share of the business’s profits on their individual tax return. There are several limited circumstances where a partnership would owe taxes at the entity level. This is the section where these tax liabilities would be recorded.
  • Answer questions on Schedule B. Stretching over all of Page 2 and on to Page 3 of Form 1065, Schedule B can be thought of as a questionnaire that encompasses various areas of your business. The questions range from asking what specific type of partnership your business is, to reporting ownership interest by partners.
  • Complete Schedule K. This schedule is what will be used to allocate dollar amounts and other information from From 1065 to the partners.
  • Complete Schedule L. If required, complete Schedule L. This is where you would report your business’s balance sheet.
  • Complete Schedule M-1. This schedule is where you reconcile taxable vs. non-taxable income and deductible vs. non-deductible expenses.
  • Complete Schedule M-2. This schedule is a more detailed look at the partners’ equity accounts.

Information from your Form K-1

The K-1 you receive from your partnership will contain the following information to report on your individual income tax return: 

  • Ordinary business income or loss; 
  • Rental income or loss; 
  • Guaranteed payments; 
  • Interest income; 
  • Dividend income; 
  • Royalties; 
  • Capital gains or losses; 
  • Other business gains and losses; 
  • Other income or losses; 
  • Section 179 Expense; 
  • Self-employment earnings;
  • Tax credits; 
  • Items that affect alternative minimum taxable income; 
  • Tax-exempt income and nondeductible expenses; 
  • and Distributions from the partner’s equity accounts.

This is just a quick overview of Form 1065 and Form K-1. Please call our office if you have any questions about filing a tax return for your partnership or how to report K-1 information on your individual tax return.

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Partnership Tax Deadline

Tax returns for calendar-year partnerships are due March 15 so the business has plenty of time to send Form K-1s to all its partners in time for them to file their individual tax returns by the April 18 deadline.

Disclaimer: This page is not intended to be the rendering of legal, accounting, tax advice, or other professional services. Articles are based on current or proposed tax rules at the time they are written, and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.

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