As with all types of businesses, a partnership also has to contend with taxes. Before we take a look at how partnerships are subject to tax, let us understand what a partnership is.
What Is A Partnership?
A partnership is an association between two or more people, who decide to go into business, for the purpose of making a profit and sharing in them. A partnership does not have to be bound by a written agreement. If you are running a business with one or more other persons, with the intention of sharing in the profits and losses of the business, then you are said to be in a partnership. A partnership can be of two types:
Partnerships and Taxes
A partnership, regardless of what type, does not pay taxes as a separate unit from its partners. In a partnership, any profits are passed on to the partners, who are then responsible for paying any taxes on them. The partnership firm on the whole is not required to pay any taxes, but it does have to file a return. The tax return is only for informational reasons and not to pay any actual tax. The return informs the IRS as to the amount of profit made by the partnership and also how it was shared among the partners.
Taxes and Distributive Share of Partners
In a partnership, each partner has to pay income tax according to his or her distributive share of the profits. A ‘distributive share’ implies the share of the profits that has accrued for each partner, but not necessarily paid to the partners. For instance, if your share of profits from a partnership is $10,000, then you need to pay income tax on that amount regardless of whether you took the actual profits or you left them in the partnership as an investment, or for expansion, or any other purpose.
In effect, if the partnership has made any profits, then each partner has to pay income taxes on their portion of the profits, even if they do not withdraw any of the profits from the partnership. The distributive share of each partner is generally detailed in the partnership agreement. If a partnership agreement does not exist, then each partner is said to have a portion in the profits (or losses) in proportion to their ownership in the partnership. So, if you own 75% of your partnership business, then you are entitled to 75% of its profits (or losses), and have to pay taxes on that 75%.
Partnerships and Special Allocation
The profits or losses in a partnership need not be distributed according to the ownership interest of each partner. If you wish to divide the profits and losses (and consequently your tax liability) in your partnership in a manner that is not proportionate to the ownership interest of partners, then you can do so through what is called a special allocation. However, the IRS does not always allow special allocation and you may need to consult with an attorney to determine whether or not your particular circumstances qualify for a special allocation.
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