Working with a partner brings its own particular set of tax rules. Entrepreneurs should be aware of them to avoid penalties and risks
A partnership is a particular type of business structure that has its own set of tax requirements. There are several benefits to forming partnerships, including the combined skills, knowledge, and resources of the co-owners. And understanding how they operate is key to understanding each year’s tax responsibilities.
The IRS classifies partnerships as pass-through entities, meaning that they are not separate entities from their owners. Each partner contributes something to the business, whether it’s property, labor, or money, and then receives a share of the income or loss.
Instead of partners receiving a regular salary, as they would as an employee, they get a certain amount of money each year based on their share of the partnership, which is usually outlined in a partnership agreement.
Tax reporting requirements
Come tax time, partnerships don’t have to pay income tax themselves. All income and losses are passed through to the partners, who then report that income or loss on their personal income tax returns, Form 1040, Schedule E.
Even though partnerships don’t pay federal income tax, an annual information return must still be filed with the IRS which reports the business’s income, deductions, gains, losses, and more. The forms that partnerships are required to submit are Form 1065, an informational return, and Schedule K-1, which delineates the partners’ shares of the business’s income and losses. Schedule K-1 is then filed with each partner’s personal tax return.
Partnerships also may need to file a state tax return and pay excise, franchise, or sales taxes. Since each state has different requirements, it’s important to work with a tax professional to ensure that you’re covering all aspects of your responsibilities.
Estimated taxes for partners
Because partners don’t have an employer taking out income taxes throughout the year, they must pay estimated quarterly taxes to the IRS on their share of profits. This amount is known as a partner’s distributive share, which is outlined in the partnership agreement. It’s important to note that even if this amount doesn’t match what a partner actually withdrew from the business, that is still the estimated amount on which taxes are owed.
These estimated self-employment taxes consist of Social Security and Medicare contributions that would normally be taken out by an employer. The bad news is that partners could end up paying twice as much in taxes than they would if they were a regular employee since the contributions made by employees are usually matched by the employer. The good news is that half of a partner’s self-employment tax contribution is deductible, helping lower the tax burden.
Pass-through and other deductions
As a partner, you may be able to deduct 20 percent of business income with the pass-through deduction that was introduced by the Tax Cuts and Jobs Act, known as the qualified business income (QBI) deduction. Owners of sole proprietorships, partnerships, S corporations, and some trusts and estates that meet certain qualifications can deduct up to 20 percent of their QBI, plus 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
For 2019, $321,400 is the income threshold if a taxpayer is married and filing jointly, and $160,700 if they are single. As long as income is under this threshold, the pass-through deduction is 20 percent of QBI.
Other applicable deductions are the costs of the partnership operations, including travel expenses, start-up costs, and other small business tax deductions. These deductions lower your tax burden by lowering the profit you report to the IRS.
Working with a tax professional
Knowing the basics of how partnerships are taxed is important, but it’s a good idea to meet with a tax professional to ensure that you do everything correctly. Paying estimated self-employment taxes and claiming deductions are complicated for partnerships, so you never want to risk making a mistake or overlooking a tax break. This is especially crucial if you’ve just formed a partnership and are filing the informational tax return or are paying estimated self-employment taxes for the first time.
For strategic tax guidance, get in touch with Provident CPA & Business Advisors. We help clients pay the least amount of tax legally possible, help you get the most out of your chosen business structure, and work with entrepreneurs to maximize growth and profit.