How Partnerships Are Taxed
What does it mean to be a “pass-through” tax entity in the eyes of the IRS?
For many small businesses, paying income tax means struggling to master double-entry bookkeeping and employee withholding rules while ferreting out every possible business deduction. For partnerships, paying taxes also involves understanding difficult terms like "distributive share," "special allocation," and "substantial economic effect." Here, we demystify some of these complexities and explain the basics of how partnerships are taxed.
How Partnership Income Is Taxed
Generally, the 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 individual income tax returns. Each partner's share of profits and losses is usually set out in a written partnership agreement.
Filing Tax Returns
Even though the partnership itself does not pay income taxes, it must file Form 1065 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 to the IRS and to each partner, which breaks down each partner's share of the business's profits and losses. In turn, each partner reports this profit and loss information on his or her individual tax return (Form 1040), with Schedule E attached.
Estimating and Paying Taxes
Because there is no employer to compute and withhold income taxes, each partner must set aside enough money to pay taxes on his share of annual profits. Partners must estimate the amount of tax they will owe for the year and make payments to the IRS (and usually to the appropriate state tax agency) each quarter -- in April, July, October, and January.
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