As the word itself describes, Partnership is a business legally owned by two or more owners. Since partnerships have no corporate status, they do not have to be taxed directly by the IRS. The individual partners who received the profits as personal income will be taxed by the IRS instead. It’s an arrangement of at least two people engaging in a business that’s not under any corporate entity.
It’s important to remember that when filing your personal income tax return, you have to properly report your profits and losses from your partnerships to avoid tax issues that may occur later on. The difficult terms use when paying taxes can be a challenge for anyone who’s not familiar with the tax system, which is why we prepared a basic explanation of how partnership taxation works.
How Partnership is Taxed
The IRS generally consider partnerships and owners the same when it comes to taxation. The term “pass-through” tax entities are used by the IRS to describe the passing through of profits and losses from the partnership to the business partners. In other words, it is the owners who will be taxed on their share of profits or losses and not the partnership and will be included on their individual income tax returns. A written partnership agreement is set out for the each partner’s share of profits and losses.
How Tax Returns is Filed
A Form 1065 is filed by the partnership that will include the taxable income earned by the partnership and each partner’s income. It’s important to report the income correctly using this form since the IRS will be reviewing it. A Schedule K-1 will be issued to each of the partners that contain the amount of partnership income assigned to them including their personal income tax returns. Each partner, on the other hand, will report the profit and loss of the business in their individual Form 1040 with an attached Schedule E. Lastly, before you even receive your Form K-1, make sure you estimated the right tax amount owed. You must have sufficient funds to pay your taxes.
How Distributive Share Works
The IRS will tax each partner base on the distributive share which is the partner’s percentage of profits share. Even if there is an agreement that states the partner agrees to a certain amount of profit that should remain within the partnership, it's no longer the IRS’s business. What matters is that the share of each partner is determined. In case no written partnership agreement exists, the profit of the partnerships will be divided equally. There is a term called especially allocation for situations like splitting up profits and losses that are unproportionate to the partner’s percentage interests in the business but IRS rules have to be followed accordingly.
What is Self-Employment Taxation
The IRS will require owners of partnership to pay self-employment taxes from the share of the partnership of profits in addition to income taxes. Just like any employees would typically pay, you will be required to pay taxes that’s compose of your contributions to the Social Security and Medicare System. The difference between the contributions of a regular employee and a partner is that employers never withholds taxes from partner’s paychecks. Partners will have to pay their regular income taxes and will pay double than that of a regular employee since the contributions made by the employee is matched by their employers.
How Will Incorporating Your Business Benefit You
In some cases, forming a corporate entity may offer tax advantages for you. If your business is a corporation, you will be taxed directly by the IRS and can pay through the corporation. Taxes for a partnership, on the other hand, is paid through the partner’s individual tax returns.
Another advantage is the fact that the corporate tax rate for income up to $50,000 is 15 percent and 25 percent for $50,000 and $75,000. Which means if ever the partners agree to leave their profits in the partnership for business expansion or to cover future expenses amounting to $50,000 it is better to form a corporation. This is because partnerships still pay personal income tax left in the partnership with a tax rate of 25 percent for income between $34,000 and 82, 000 while the corporation has a low 15 percent tax rate in the same bracket.
