Introducing the partnership
After ruling out operating as a sole proprietorship or corporation, you may be wondering which ownership options remain.
This is where the expression, “two heads are better than one,” comes to mind. When other structures just don’t fit into your small business goals, you may want to consider bringing a trusted friend, family member, or professional contact on board to form an ownership team, otherwise known as a partnership.
In a partnership, each owner contributes financially and shares their relevant experience and knowledge.
The partnership differs from a sole proprietorship in that it is owned and managed by multiple partners rather than a single owner. Unlike a corporate tax structure, it’s not a legally separate business entity owned by shareholders. You and your partners are co-owners who share the business’s income and losses.
The downside to this arrangement is that all partners are personally liable for the business’s debts. If one of your partners makes a questionable business decision, you share the financial consequences.
How partnerships are taxed
As is the case with a sole proprietorship, a partnership is considered a pass-through entity for tax purposes. In other words, the partnership itself is not taxed, but each partner is responsible for reporting their own profits and losses from the business on their individual tax returns.
A clear advantage to the partnership taxation method is that the profits in your partnership are only taxed once. This is opposed to that of a corporation, where profits are taxed once as an entity and then again individually for each shareholder.
The good news is that because partnerships are pass-through entities, the profits qualify for the deduction that is granted for pass-through business income. So, your deduction is 20% of your share of the partnership’s profit.
Why you need a written agreement
You may have complete trust in your family members or close friends as partners, and it’s tempting to just decide that a handshake agreement is all you need to run the business. But, over time, even friends and family can grow apart and endanger the business by not holding up their end of the deal.
Without a written partnership agreement, you have no legal ground to stand on should your partners’ actions and decisions jeopardize the business. A written partnership agreement drawn up ahead of time stipulates everyone’s roles, clarifies an exit plan for the partners, and may also include a non-compete clause. Your partnership agreement should also state the partner’s share of profits, losses, deductions, and credits.
How profits are distributed in a partnership
Profits in a partnership are divided amongst the partners according to the partnership agreement, and can either be distributed to the partners or reinvested back into the business.
This is where the partnership agreement can be a valuable time-saver. Without an agreement that details the allocation of each partner’s distributive share, this amount must be calculated using other variables. These may include the partner’s service contributions and capital investments.
It’s important to mention that not all distributions have to be equal in your partnership. Just because both business owners put in 50% of the business’s capital does not automatically entitle them to receive 50% of the profits. Instead, the partnership agreement can stipulate that the partner receives a specific percentage of the partnership profits, regardless of their initial investment.
For example, let’s say Carl and Roberto are business partners who invested $100K apiece in a pizza restaurant. Despite the fact they both invested equally, their partnership agreement states that Carl will be allocated 60% of the partnership profits while Roberto gets 40%. This unequal allocation may be appropriate for various reasons. In this case, Carl spends more time working in the restaurant than Roberto does, entitling him to a greater share of the profits for the extra hours he works.
Partners may also opt not to receive their share of the profits as a distribution and choose instead to reinvest them back into the business. In our above example with Carl and Roberto’s pizza business, their restaurant realized a $100K profit in the last tax year. But, rather than taking their respective distribution, the two partners agreed to reinvest the combined amount to expand the restaurant’s seating area since business is booming.
However, keep in mind that just because the partners did not take a distribution doesn’t mean they don’t pay income taxes on them. Instead, the profits are considered allocated, and Uncle Sam still gets his cut.
Learn more: Owner’s Draw vs. Salary: How to Pay Yourself
How to file taxes for a partnership
IRS Form 1065
The allocation of profits or losses for all partners is calculated and recorded on Form 1065 at the end of each fiscal year. This form reports the partners’ gains, losses, credits, and deductions to the Internal Revenue Service. There is no tax reported on Form 1065 since the partnership is a pass-through entity, and the partners report and pay taxes on their personal income tax returns.
Completing Form 1065 is a pretty straightforward process. Revenues and expenses are listed on the first page. The partnership’s profit or loss is obtained by calculating the difference between the total expenses and total revenues.
The second and third pages of the form are just a series of yes or no questions describing your partnership. These include if any partners are not U.S. residents or if your partnership held any accounts outside the U.S.
Schedule K, the last part of Form 1065, breaks down the partnership’s income into several categories. These include ordinary business, rental income, and interest income.
Finally, separate Schedule K-1 forms are filled out and distributed to each partner. A Schedule K-1 details their share of the income, credits, and deductions that each partner reports on their individual income tax returns.
In our example with Carl and Robert’s restaurant, their K-1s show an ordinary income of $60,000 and $40,000 respectively, with interest income of $1,000. Their individual 1040 tax returns will carry their respective K-1 amounts as part of their total income for the year. They will also carry over their half of the interest income of $500 to their individual tax forms.
Paying estimated taxes
Since federal income tax is not withheld from the distributions, individual partners are responsible for their own tax payments. This is where quarterly estimated taxes enter the picture.
But how can you estimate your taxes if you don’t even have your profit numbers yet? You can use the worksheet included on page 8 of 1040-ES, but if you prefer a slightly more user-friendly method, follow our step-by-step estimated quarterly tax calculator to figure out how much you owe.
Most employees pay into the Social Security and Medicare programs through payroll deductions. Partners, on the other hand, do not receive paychecks, so they are required to submit these payments to the IRS in the form of a self-employment tax on their allocated profits. Although this tax is filed along with your annual income taxes, it is not taxed the same way.
The self-employment tax rate is 15.3% on net earnings of $400 or more. This rate combines both the Social Security and Medicare contributions at 12.4% and 2.9%, respectively.
The catch to paying self-employment taxes as partners is you are paying double. This is because the 15.3% is normally split 50-50 between employer and employee. But, without this arrangement, partners are on the line for the entire amount. Fortunately, you can deduct half of your self-employment taxes from your own taxable income to compensate for the added amount.
Self-employment taxes are filed annually using Schedule SE along with your Form 1040.
Learn more: What is Self Employment Tax?
Partnership tax deadlines
Not all IRS filing deadlines are created equal. This is especially the case with partnership returns. Unlike most returns that are due on April 15th (or the next business day), the IRS deadline for partnerships is actually a month earlier on March 15th.
If you find yourself behind in filing, don’t panic. The IRS gives you until September 15th before applying any penalties, but you will have to request an extension. Simply file Form 7004 on or before the March 15th due date to request an automatic extension. But don’t forget that with an extension, you still need to pay an estimated amount of taxes on the original March 15th due date.
Don’t forget to keep track of the deadlines for filing your quarterly estimated taxes. See the table below for estimated tax payment due dates in 2024.
Note: due dates that fall on a weekend or a legal holiday are shifted to the next business day.
Should you miss any of the above quarterly deadlines, it’s important that you make the payment as soon as you can to head off additional penalties and interest.
How Bench can help
With Bench’s monthly bookkeeping services, your partnership is tax-ready from day one all the way through to year end. When we close your books, we provide you with a year end financial package containing all the information a tax professional needs to file your taxes. If you want, we can even file your taxes for you. Learn more.
The bottom line
Running your small business as a partnership can be a rewarding and profitable experience. Your small business realizes several benefits as a partnership, including potential tax savings. Before you jump into an ownership team, though, it’s crucial that each partner has a thorough understanding of their roles in the business.