Fundamental Federal Tax Rules for Partnerships Focus on Fundamental concepts pertaining to partnerships Most common and important transactions and applicable tax rules at the creation and operational stages of a partnership What is a Partnership Generally a partnership is an association between two or more taxpayers who join to carry on a trade or business for profit Generally a partner can be any type of entity i e individual corporation estate trust even another partnership Types of Partnerships General Partnership every partner has unlimited liability for the debts of the partnership Limited Partnership at least one partner s liability for the debts of the partnership is limited to that partner s investment in the partnership Limited Liability Partnership LLP type of general partnership in which all of the partners all of which are general partners are protected at a minimum from personal liability for negligent acts committed by other partners or by employees not under his or her direct control Types of Partnerships Cont Limited Liability Company LLC owners can all participate in the management of the business but who also are all given protection from the liabilities of the LLC except to the extent of their investment in the LLC LLCs are NOT legally a partnership but usually treated as a partnership for Federal income tax purposes for those LLCs with two or more members so long as an election has not been made to be treated as a corporation for tax purposes This is generally the most beneficial form of a business from a tax and non tax perspective the best of both worlds Classification of Partnerships for Federal Income Tax Purposes There are 3 general sets of regulatory rules that classify entities for income tax purposes Incorporated vs Unincorporated Businesses 1 A business activity incorporated under the law of any state federal or foreign jurisdiction must be treated as a corporation for federal income tax purposes either as a C corporation or an S corporation Incorporated vs Unincorporated Businesses 2 Unincorporated entities such as partnerships and LLCs may elect to be a corporation for tax purposes If it does not elect to be treated as a corporation note that this election is rare in practice a multi owner unincorporated entity is by default treated as a partnership for tax purposes Disregarded Entities 3 A single member unincorporated entity is treated as a disregarded entity i e is the same as its owner for Federal income tax purposes unless it elects to be treated a corporation for tax purposes Example A single member LLC For single member LLCs you look to the type of owner for example an individual or a corporation to determine the tax classification Partners as Employees A partner usually does not qualify as an employee for tax purposes resulting in the following tax consequences A partner who receives guaranteed payments from the partnership is not subject to tax withholding on these payments A general partner s 1 distributive share of ordinary partnership income and 3 guaranteed payments for services are generally subject to the Federal self employment tax 10 Advantages Disadvantages of Partnerships Advantages of Partnerships Flow Through Taxation Flow through Taxation For Federal income tax purposes the partnership itself is not taxable Income flows through to the partners and is then recognized by them Advantages of Partnerships Flow Through Taxation Cont 2 positive effects of flow through taxation 1 Income is only taxed once at the partner level as opposed to the double taxation that C corporations and shareholders experience 2 If a loss occurs the partner will often be able to deduct her share or a portion of her share of the loss In contrast C Corporation shareholders are not allowed to deduct any portion of the corporation s loss on their tax return the loss is retained by the corporation The four loss limitation rules will be discussed later Advantages of Partnerships Cont Property Distributions Generally distributions of property from a partnership to partners are tax free and cash distributions are also normally tax free so long has the partner has sufficient basis in the partnership to be discussed later Vs Distributions of property from a C corporation however are normally taxable dividend income to the shareholder and are normally nondeductible by the corporation i e the second part of the double taxation problem of C corporations Advantages of Partnerships Cont Tax free Formation Generally for a corporation to be tax free property must be contributed stock must be received and 80 percent control must be owned by the contributors after the contribution No such 80 control requirement exists for partnerships to be discussed shortly Contributions to partnerships are generally tax free Other Advantages Easy to Form No filing with the state at least for a general partnership and no required paperwork However a written partnership agreement is strongly advised Liabilities of a partnership increase a partner s basis in the partnership unlike the general rule for S corporation shareholders Disadvantages of Partnerships Unlimited Liability General partnerships and limited partnerships don t fully shield their general partners from the liabilities of the partnerships This is one reason why so many businesses operate as LLCs where multi member LLCs are generally taxed as partnerships but their owners are normally shielded from the liabilities of the entity if they comply with all of the LLC legal formalities Disadvantages of Partnerships Cont Self employment Income Any trade or business income is taxed to the general partners as self employment income which is subject to the self employment tax But not having partners who perform services for the partnership on payroll is often viewed as an advantage less administrative work Guaranteed payments for services provided by all partners including limited partners is also treated as self employment income subject to SE tax Other Disadvantages of Partnerships LLCs More difficult to transfer ownership vs corporation More difficult to raise capital vs corporation Shared Expenses Distinguished Generally a partnership doesn t exist if the joint undertaking is made for the sole purpose of sharing expenses It would be a partnership if the members hold themselves out as partners to third parties conduct their business under their combined names or pool their money to share profits Guaranteed Payments Payment to partner