Partnerships do not pay taxes on their generated income. The Internal Revenue Service (“IRS”) classifies a partnership as a “pass-through entity”. The income and tax liabilities are passed through to the partners. Instead of taxing the partnership, the IRS taxes the partners based on their percentage of the business income.
The partners are required to report their share of profits or losses on their own individual income tax returns. Partners may also be required to pay self-employment taxes on the income of a partnership.
Additionally, the amount of taxes that a partner needs to pay may also be tied to the percentage of income contained in the partnership agreement. For example, in a limited partnership, the limited partners (as opposed to the general partners) will only be required to pay taxes that reflect what they initially invested in the business.
Some other important tax requirements that owners of a partnership need to be familiar with include:
- Estimated or quarterly taxes (i.e., Form 1040-ES)
- Supplemental income and loss taxes (i.e., Schedule E, Form 1040)
- Income and self-employment tax forms specified for seniors (i.e., persons who are 65 years of age or older)
- Various international tax forms if the company does business or owns property overseas
Even though the partnership does not directly pay income taxes, it is responsible for reporting partnership income. The partnership can do this by filing an annual information return with the IRS that includes any deductions, gains, income, losses, and so forth of the partnership.
Are Limited Liability Companies Treated Differently?
The tax requirements for limited liability companies can be very confusing. A limited liability company takes on the properties of a partnership regarding management styles and tax arrangements. Owners of a limited liability company are required to report any revenue that results from the business on their personal income tax returns.
Depending on the jurisdiction, a percentage of the limited liability corporation’s profits will be taxed per the income tax rate that applies in that specific state. An owner of shares in a limited liability company may also be liable for paying self-employment taxes on any profits earned, but only if they partake in making management-level decisions. Investors who cannot make management-level decisions do not have to pay self-employment taxes.
In addition, how the IRS treats a limited liability company will depend on what the members checked off on their incorporation documents when they elected their tax status. According to the IRS, a domestic limited liability company with at least two members will be classified as a partnership for federal tax filing purposes unless it elects another tax status. That is, the default position is that a limited liability company will be taxed as a partnership.
On the other hand, if the members elect to be taxed as a general corporation even though the business is still organized as a limited liability company, then the company will be subject to double taxation laws. This means that the limited liability will be taxed on its income, and the members will also be taxed on their portion of the income.
However, this will only happen if the members choose to be taxed like a C corporation. If the members choose to be taxed as an S corporation, they will be taxed in the same manner as standard partnerships and sole proprietorships.
Members of limited liability companies who request to be taxed like a C corporation will differ in that:
- They will be taxed at both the corporate tax rate and the personal income tax rate (i.e., double taxation)
- They may need to pay franchise taxes
- They will need to abide by corporate tax requirements
A business owner or member must consult a local business attorney to assist with structuring their business to obtain the best tax status for them. As most people know, the question of taxation can be particularly complex. An attorney should be consulted unless the company members fully understand the requirements or if they have a question about taxes in their specific industry.
An attorney can explain the tax obligations that a business owner has and can ensure that they comply with the relevant tax laws in their state. An attorney may also be able to offer advice on different ways that an owner might potentially be able to reduce the amount that they owe in overall taxes legally.
In sum, the only time a limited liability company may be taxed differently than a partnership is if it elects to be taxed as a C corporation. Otherwise, the tax requirements for most limited liability companies and partnerships are practically the same.
What Are the Tax Consequences of Incorporation?
While it does not happen very often, there are several ways to incorporate a partnership. The partners can either:
- Modify the business entity and transform it into a corporation, limited partnership, or limited liability company
- Transfer the assets of the partnership to the new corporation
- Incorporate it and register it with the state
The most common reason that partners would choose to incorporate is defensive. If a partnership gets sued, the partners are fully liable for any money the partnership owes. A corporation protects the owners because if a corporation gets sued, only the company is liable for any amount they must pay.
Moreover, for some businesses, it may be beneficial to get incorporated since corporations can earn income and may pay income taxes before profits are distributed. These distributions can then be taxed to the owners as dividends instead of income, which can benefit business owners.
As discussed above, however, there are also negative consequences that can stem from incorporation. Some of these include:
- Having to pay a corporate tax rate (currently at 21%);
- Having to pay income tax rates
- Being subjected to double taxation
- Having to pay self-employment taxes regardless of a partner’s status (e.g., limited vs. general partners)
- Possibly having to pay excise or franchise taxes.
Thus, for partners in a partnership or members of a limited liability company, it may be wise to stick with the default tax status assigned to each of these respective business structures. It can save a business owner time, money, and a lot of resources if they maintain their tax status.
The only scenario in which it might make sense to take a risk is if a business is growing rapidly, can afford to make the switch, would benefit from being incorporated, and, most importantly, was advised by a business attorney that it was a low-risk move for the company.
Do I Need a Lawyer?
The tax laws surrounding the different business structures can be very difficult to interpret without legal assistance. An experienced corporate attorney will be able to explain the various federal and state tax requirements you must comply with as a business owner.
Thus, if you are a business owner and want to ensure that your company is taxed in the most economically advantageous manner, then it may be in your best interest to contact a local tax attorney for further advice.
Your attorney can also discuss the risks and liabilities associated with the type of business you run and determine whether there is a better-suited model for your business. If there is, your attorney can assist with the paperwork and can help you file amended registration forms.
Finally, if you believe there is an error with the amount you owe in business taxes, your attorney can communicate with the IRS on your behalf and guide resolving a tax law issue.
