Forming A Partnership? What To Expect At Tax Time

If you're going into business with other individuals, you're probably considering the formation of a partnership. A business partnership allows you to harness the capital, skills, and natural strengths of different owners so that the business can thrive.

But there are new financial considerations to make to create and maintain this type of business entity. For example, it affects the way that taxes are filed and paid. How? And how can you minimize the financial impacts? Here are a few answers.

How Partnership Taxes Differ From Others

Different business entities — sole proprietorships, limited liability companies, corporations, and partnerships — have different obligations when it comes to income taxes. A corporation, for instance, files its own income tax returns as an entity and is responsible for paying the income taxes due. 

Partnerships, though, do not pay income taxes as a business. Instead, the business will maintain records of income and losses, then report these to the federal and state tax agencies on an informational return — generally Form K-1. You will need to make sure that the partnership hires a tax preparation service to prepare Form K-1 and distribute a copy to each partner. This form stipulates your share of the business income (or loss) as well as some deductible items. 

Partners' Additional Responsibilities

Because the partnership has only limited reporting responsibilities for taxation, each partner must be proactive about reporting and paying their personal income taxes. Using Form K-1, then, you must report your share of the company's profits on your own Form 1040 and pay the required taxes. Failure to report any income will cause liability to you personally rather than to the partnership. 

You will also be responsible for paying self-employment taxes. This federal tax is imposed on those who work for themselves, and it pays for each person's full share of Social Security and Medicare tax obligations. As a partner, you will be liable for both the employer and employee amounts. 

Even though this is just one additional source of income, partners should not treat it as simply equal in complexity to other sources of income (such as wages or even independent contractor work). It's actually quite a bit more complicated. Certain items are separately stated on the partnership's form, for instance — including things like capital gains or losses, tax-exempt income, and charitable contributions. Each partner must then determine the correct use of such separately stated items on their personal tax returns. 

The more you understand how partnership taxes affect you and what to expect, the better you can prepare for and minimize your tax bill. And then you can focus on the important goal of running a thriving business.