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How to Form a Partnership for Tax Purposes

September 23, 2015

Amber A. Monaghan, CPA, MSAT
Director

A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and receives a proportionate share in the profits and losses of the business.

Generally, the Internal Revenue Service (IRS) does not consider partnerships to be separate from their owners for tax purposes; instead, they are considered "pass-through" tax entities. This means that all of the profits and losses of the partnership "pass through" the business to the partners, who pay taxes on their share of the profits (or deduct their share of the losses) on their respective income tax returns. Each partner's share of profits and losses is usually set out in a written partnership agreement. This step is not legally required, but it is highly advisable that partners execute a formal agreement.

Even though the partnership itself does not pay income taxes, it must file Form 1065, U.S. Return of Partnership Income, with the IRS. This form is an informational return the IRS reviews to determine whether the partners are reporting their income correctly. The partnership must also provide a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., to the IRS and to each partner, which breaks down each partner's share of the business' profits and losses. In turn, each partner reports this profit and loss information on their respective income tax return (for individuals, this is Form 1040, U.S. Individual Income Tax Return, with Schedule E, Supplemental Income and Loss, attached).

Types of Partnerships

There are three general types of partnership arrangements:

  • General Partnerships assume that profits, liability and management duties are divided equally among partners. If you opt for an unequal distribution, the percentages assigned to each partner must be documented in the partnership agreement.

  • Limited Partnerships are more complex than general partnerships. Limited partnerships allow partners to have limited liability as well as limited input with management decisions. These limits depend on the extent of each partner’s investment percentage.

  • Joint Ventures act as general partnership, but for only a limited period of time or for a single project. Partners in a joint venture can be recognized as an ongoing partnership if they continue the venture, but they must file as such.

Limited Liability Company

A limited liability company (LLC) is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The “owners” of an LLC are referred to as “members.” Depending on the state, the members can consist of a single partner (one owner) or two or more partners (individuals, corporation or other LLCs). Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their respective income tax returns, just like the owners of a partnership would.

Forming a Partnership

To form a partnership, you must register your business with your state, a process generally done through your Secretary of State’s office.

You’ll also need to establish your business name. For partnerships, your legal name is the name given in your partnership agreement or a name agreed to by the partners.

Entity Classification Election

A business operated by two or more owners can elect to be taxed as a partnership by filing Form 8832, Entity Classification Election. A business is eligible to elect partnership status if it has two or more members and:

  • is not registered as anything under state law,

  • is a partnership, limited partnership or limited liability partnership, or

  • is a limited liability company.

Publicly traded businesses cannot elect to be treated as partnerships. They are automatically taxed as corporations.

Form 8832 allows a business to select its classification for tax purposes by checking the box on the form: partnership, corporation or disregarded. If no check-the-box form is filed, the IRS will assume that the entity should be taxed as a partnership or disregarded as a separate entity. An LLC that makes no federal election will be taxed as a partnership if it has more than one member and disregarded if it has only one member. An LLC must make an affirmative election to be taxed as a corporation. The IRS language on Form 8832 uses the term "association" to describe an LLC taxed as a corporation.

Form 8832 has no particular due date. There is a space on the form (line 8) for the entity to note what date the election should take effect. The date named can be no earlier than 75 days before the form is filed, and no later than 12 months after the form is filed. It is most important to file Form 8832 within the first few months of operations if the entity desires a tax treatment that differs from the tax status the IRS will apply by default if no election is made.

A few businesses do not qualify to be partnerships for federal tax purposes. These are:

  1. a business that is a corporation under state law,

  2. a joint stock company (a corporation without limited liability),

  3. an insurance company,

  4. most banks,

  5. an organization owned by a state or local government,

  6. a tax-exempt organization,

  7. a real estate investment trust, or

  8. a trust.

Although these businesses cannot be partnerships, they can be partners in a partnership (they can join together to form a partnership).

Of course, whether your business is best operated as a partnership, as a corporation or as another type of entity should not only be driven by short-term tax considerations. How you envision your business will develop over time, whether your business is asset or service intensive and what personal financial stake you plan to take, among others, are all additional factors that should be considered.

 

Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein.  Such content, comments, or advice may be based on tax statues, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities.  This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.

 

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