How Partnerships are Taxed
For small businesses, paying income tax means mastering double-entry bookkeeping and employee withholding rules while finding business deductions. For partnerships, paying taxes also involves understanding terms like “distributive share,” “special allocation,” and “substantial economic effect.”
Here, we explain how partnerships are taxed.
Partnership income is taxed
The IRS does not consider partnerships separate from their owners for tax purposes; they are “pass-through” tax entities. This means that all profits and losses of the partnership pass through to the partners, who pay taxes on their share of the profits (or deduct their share of the losses) on their individual income tax returns. Each partner’s share of profits and losses is typically outlined in a partnership agreement.
Filing tax returns
Although the partnership itself doesn’t pay income taxes, it must file Form 1065 with the IRS. This form is an informational return that the IRS reviews to ensure the partners are reporting their income correctly. The partnership must also provide a “Schedule K-1” to the IRS and each partner, which breaks down each partner’s share of the business’ profits and losses. Each partner reports this information on their individual Form 1040, with Schedule E attached.
Estimating and paying taxes
Since there is no employer to withhold income taxes, each partner must set aside enough money to pay taxes on their share of annual profits. Partners must estimate their tax liability for the year and make quarterly payments to the IRS (and to the state tax agency) in April, July, October, and January.
Taxation of profits
Each partner must pay income taxes on their “distributive share” of profits. This is the portion of profits the partner is entitled to under the partnership agreement or state law. Partners must pay taxes on their share of the partnership’s profits, regardless of how much money they actually withdraw from the business.
Establishing partners’ distributive shares
In the absence of a partnership agreement stating otherwise, profits and losses are usually allocated to partners according to their percentage interests in the business. This determines each partner’s distributive share. If partners want to split profits and losses in a way that isn’t proportionate to their percentage interests, it’s called a “special allocation,” and they must follow IRS rules.
Self-employment taxes
Actively involved partners must pay “self-employment” taxes on all partnership profits allocated to them. Self-employment taxes include contributions to Social Security and Medicare. Partners must pay these taxes along with their regular income taxes. However, partners must pay twice as much as regular employees because employer contributions are not withheld from their paychecks.
Expenses and deductions
Partners can deduct legitimate business expenses from their business income, reducing the profits reported to the IRS. Deductible expenses include start-up costs, operating expenses, and business-related meals, travel, and entertainment expenses.
Get expert help
Partnership taxes can be confusing, so it’s recommended to read "Tax Savvy for Small Business" and seek help from a tax advisor specializing in partnership taxation to ensure compliance with complex tax rules and the IRS.
Incorporating your business may reduce your tax bill
Unlike partnerships, corporations are separate entities from their owners and pay their own taxes. Owners of corporations only pay income taxes on money received as compensation or dividends. Incorporating can offer a tax advantage over a partnership’s pass-through taxation, especially for businesses that retain profits in the business from year to year.
Retained profits in a partnership are taxed at the individual tax rate, while incorporating can result in taxation at the lower corporate rate. It is recommended to review the specifics of how corporations are taxed to determine the potential benefits of incorporation for reducing taxes.
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