A partnership does not pay taxes as an entity. However, it must figure its profit or loss and file a return. Unlike sole proprietorships, there are special forms to be filed by the partnership, notably, Form 1065, Schedule K and Schedule K-1 together with any supporting statements (§701; Reg. §1.7011).
Partnerships are “tax conduits.” As such, they distribute directly to the partners, on a pro-rata basis, all items of income, deduction, credit, gain, and loss. The partners are then responsible for reporting these items on their own individual income tax returns. As with sole proprietorships, partners are responsible for the payment of self-employment taxes on their net partnership income.
Regularly, a partner’s share of earning, gain, loss, deductions, or credits is determined by the partnership agreement (§704(a); Reg. §1.704-1(a)). The partnership contract includes the original agreement and any modifications of it agreed by the partners or accorded in any other manner provided by the partnership agreement. The agreement or modifications may be oral or written (Reg. §1.761-1(c)). A partnership agreement may be modified for a particular tax year after the close of that year, but not later than the date, excluding any extension of time, for filing the partnership return (Reg. §1.704-1(b); Reg. §1.761-1(c)).
The advantages of a partnership include:
(1) Earnings are taxed to the partners and not to the partnership;
(2) Distributed earnings are not subject to double taxation;
(3) Losses and credits generally pass through to partners;
(4) The liability of limited partners is normally limited to in a corporation;
(5) There can be more than one type of partnership interests;
(6) Partners conquer a basis for partnership liabilities;
(7) Special allocations are permitted; and
(8) A partnership can be used to exchange value and income within a family group by converting family members partners.
The disadvantages of a partnership include:
(1) The liability of general partners is not limited;
(2) Partners are taxed currently on earnings even if the earnings are not dis-
(3) Partners cannot exclude certain tax-favored fringe benefits from their taxable income;
(4) Partners may be required to file numerous state individual income tax re-
Turns for a multi-state partnership business;
(5) Built-in gain or loss on a property is tagged as a contributing partner; and
(6) In the absence of a business purpose, a partnership must use either a calendar year or the same year as the partners who own a majority of the interest in the partnership.
If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss on Form 1065.
Spouses should include their respective shares of the partnership income or loss on separate Schedules SE. Doing this will usually not increase their total tax, but it will give each spouse credit for social security earnings on which retirement benefits are based.
General Tax Aspects
The tax particulars of partnerships are outlined in subchapter K of the Internal Revenue Code (§701 through §761, inclusive). Partnership profits (and other income and gains) are not taxed to the partnership. Except for certain items that must be stated separately, a partnership determines its income in basically the same way that an individual does (§701; §703(a)).
The partnership, not the partners, makes most choices about how to compute income. These include choices for accounting methods, depreciation methods, accounting for specific items such as depletion, amortization of certain organization fees, amortization of business start-up costs of the partnership, and reforestation expenditures, installment sales, and nonrecognition of gain on involuntary conversions of property.
In determining a partner’s income tax for the year (on their own income tax return), a partner must take into account their distributive share (whether or not it is distributed) of partnership items. These items are furnished to the partner on Schedule K-1 (Form 1065).
Partners must treat partnership items in the same way on their tax returns as the items are treated on the partnership return. If a partner treats an item differently on their individual return, the IRS can automatically assess and collect any tax and penalties that result from adjusting the item to make its treatment consistent with the treatment on the partnership return. However, this does not apply if a partner files Form 8082 with their return identifying the different treatment (§6222).
There are two basic types of partnerships. These are limited partnerships and general partnerships.
Under the prior law, it really didn’t matter which one provided income or losses to the individual. However, since TRA ‘86, passive and active items of income deduction, credit, gain, and loss are effectively segregated for tax purposes (§469).
Investing in a limited partnership could best be described as “buying stock” in the partnership. As with a stockholder, the limited partner is essentially just along for the ride. They generally do not participate in the management of the partnership and in return are afforded the limited liability.
All income, loss, and other items received by the limited partner from the partnership are presumed to be of a passive character. Prior to TRA ‘86, an important reason to invest in limited partnerships was the generation and pass through of losses that could then be used by the limited partner to shelter other income. The effect of TRA ‘86 was to eliminate such sheltering tactics for non-corporate taxpayers, personal service corporations, partnerships, and S corporations. The effective use of these shelters was also reduced for closely held corporations and made it substantially more
difficult for larger corporations as well. The AMT, passive loss limitations and at-risk rules combine to make this quite a formidable nut to crack.