Ultimate Guide to Partnership Taxation: Understanding Your Tax Responsibilities

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Whether it’s a quick consultation or a longer-term project, we can assist you with: 

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To save money on a partnership tax return, consider:

  • Maximizing business-related deductions.
  • Keeping accurate and detailed records of all expenses.
  • Utilizing available tax credits.
  • Structuring the partnership and its transactions in tax-efficient ways.
  • Consulting with a tax professional for tailored advice, especially for strategies like income splitting or making use of certain business structures that might offer tax advantages.

The dissolution of a partnership affects your taxes in several ways:

Filing Final Partnership Tax Return: You must file a final Form 1065 (U.S. Return of Partnership Income) and indicate that it’s the final return. This includes reporting all income and deductions up to the date of dissolution.

Individual Tax Implications: Partners must report their share of income, deductions, and credits from the final partnership year on their personal tax returns.

Capital Gains or Losses: If your partnership’s assets are sold or distributed among partners, it can result in capital gains or losses for each partner, which must be reported on your individual tax returns.

Potential Recapture of Tax Benefits: Certain previously claimed tax benefits may need to be recaptured and included as income.

State Tax Considerations: State-specific tax implications may also arise, depending on the state’s laws and your partnership’s location.

Partnerships with international aspects may need to file additional forms like Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations) and Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships).

Moreover, a foreign tax credit is limited based on the US tax rate and foreign source taxable income. Partnerships must provide detailed information on Schedules K-2 and K-3 to their partners and shareholders for accurate tax reporting.

Partnerships may be subject to employment taxes, which include Social Security and Medicare taxes, income tax withholding, and federal unemployment (FUTA) tax. Relevant forms include Form 941 (Employer’s Quarterly Federal Tax Return) and Form 940 (Employer’s Annual Federal Unemployment (FUTA) Tax Return).

What is a Partnership?

A partnership is a formal business arrangement between two or more parties to jointly manage a business, and share profits and liabilities. 
Partnerships have no state-specific paperwork, and total flexibility in income and expense allocations.

However, these profits can be subjected to self-employment taxes. In addition, partners can deduct their share of business expenses on their individual tax returns. Although, how this is taxed depends on whether you’re an active or passive partner.

How does a Partnership differ from other business entities?

Similar to an S Corp, partnerships are not taxed at entity level. Instead, profits flow to partners, and are reported on their individual tax returns. This is what is called a pass-through entity. Like an LLC, each partner’s share of these profits is subject to self-employment tax.

Unlike an S-Corporation, in which profits are allocated according to the ownership percentage of shareholders, a partnership can allocate a non-proportional amount of income (or expenses) to specific partners, according to the terms of the partnership agreement.

Fusion CPA understands the nuances of partnership agreements and how this affects your tax liability.

If you have any questions, please contact us.

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What is a General Partnership?

A general partnership is a business started with at least one other person, without incorporating (or legally separating yourself from your business).

A general partnership is easy to start, as it does not require filing any paperwork with your state. It is also not held to certain compliance activities, such as recording meeting minutes. Similarly, it offers flexibility when drafting partnership agreements. 

Because partners have unlimited liability, growing a general partnership may be difficult. Individual liability can make it challenging to qualify for a business loan, attract significant clients, and build a credit history.

Our expert CPAs can advise you on how best to mitigate these risks, and choose which business entity meets your needs.

Significant areas of Partnership Taxation

  • Partnership Audit Rules – Since 2015, partnerships are subject to federal audits. A partnership can elect out of the centralized partnership audit regime for a tax year if it is an eligible partnership that year. To do this, complete Schedule B-2 of Form 1065.
  • Special Allocations – Partnerships can implement special allocations on their tax returns, based on conditions set out in their partnership agreement. For example, one partner might own 25% of the business, while the other owns 75%. This means that profits and losses are allocated according to the percentage owned by each partner.  
  • Flexibility – A partnership can elect to be taxed as a different entity, including a C Corp, S Corp, or disregarded entity. This can be done using Form 8832.

These areas can complicate tax reporting and compliance. However, our CPAs can help you navigate this with ease. 

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Most partners have to pay self-employment taxes (SE taxes). SE taxes are specifically earmarked to pay for Social Security and Medicare. 

The self-employment tax rate is 15.3%. Of this, 12.4% is for social security and 2.9% for Medicare.

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Does a Partner need to pay quarterly taxes?

A partner is generally required to make estimated tax payments. Taxes must be paid for the income you receive throughout the year. You can choose to withhold these taxes (by saving an estimated amount from gross wages to pay directly to the government), or make estimated payments. Estimated payments cover income and other taxes, such as self-employment and alternative minimum taxes. 

Deadline to pay your estimated taxes

For estimated tax purposes, the tax year is divided into four payments periods:

  • April 15th – Covers income earned from January 1 to March 31
  • June 17th – Covers income earned from April 1 to May 31
  • September 16th – Covers income earned from June 1 to August 31
  • 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 have until the following business day to submit your payment.

How to calculate your estimated taxes​

Below are suggestions to help you calculate your estimated taxes. This is done using Form 1040-ES:

  • Start by using Schedule K-1 received for your Partnership for the previous tax year.
  • Next, estimate your expected adjusted gross income, taxable income, taxes, deductions, and credit for the entire tax year, based on the current tax rates.
  • Complete Form 1040-ES using the IRS instructions or speak to one of our CPAs for assistance. 

If your estimate was too high or too low, complete a second Form 1040-ES to recalculate your estimated tax for the next submission period.

How to pay your estimated taxes​

Form 1040-ES can be submitted along with your estimated payment by mail, online, or via the IRS2Go app. You can pay your estimated taxes once-off or in installments, as long as the total amount is paid by the deadline at the end of the quarter.

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Partnership tax returns are filed on Form 1065. Each partner must also complete Schedule K-1 on their individual tax returns. K-1s record allocation of income and losses, along with other business information, such as the sale and purchase of assets.

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Tips for completing Form 1065

  • Keep up-to-date accounting records and financial statements. Accurate balance sheets and income statements ensure that you don’t report too much (or too little) income. 
  • Record your income. Your business’ income is recorded in the first section of Form 1065.
  • Record your expenses. Expenses are recorded in the second section of the form.
  • Calculate your net profit or loss. On a partnership tax return, the technical name for your business’s profit or loss is “ordinary income or loss”. To calculate ordinary income, subtract your total expenses from your gross income. 
  • Record taxes owed and payments made. Most partnerships are not taxed at the business entity level. Instead, partners pay taxes on their share of the business’ profits on their individual tax returns. However, there are circumstances in which a partnership can owe taxes at an entity level. These include penalty taxes, certain state taxes for franchising, or for large partnerships of over 100 partners. In this event, these tax liabilities need to be recorded.

Schedules of Form 1065

  • Schedule B. This questionnaire is found on page 2 and 3 of your return. It deals with a variety of topics, from the business’s stock structure to ownership interest by shareholders.
  • Schedule K. This schedule allocates the dollar amounts of each partner’s percentage of ownership, income, deductions, and tax payments. 
  • Schedule K-1. This contains information to report on your individual income tax returns, including:
    • Ordinary business income or loss
    • Other income or losses, including rental, interest, dividends, royalties, capital gains or losses
    • Section 179 expenses
    • Deductions that don’t fall within the business’s overall profit or loss for tax purposes
    • Tax credits 
    • Items that affect alternative minimum taxable income
    • Tax-exempt income and non-deductible expenses 
    • Distributions from a partner’s equity accounts
  •  
  • Schedule L. This is used to report your business’s balance sheet.
  • Schedule M-1. Here, you can reconcile taxable and non-taxable income, along with deductible and non-deductible expenses.
  • Schedule M-2. This schedule is a more detailed look at the partner’ equity accounts.

Fusion CPA can help you with tax filing, as well as how to report Schedule K-1 information

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Partnership Tax Deadline

Tax returns for partnerships are due March 15. However, Schedule K-1 must be filed with the partner’s individual tax return on April 18.

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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.