Partnerships fall into a category known as “pass-through entities” by the Internal Revenue Service (IRS). They are not considered to be separate from their owners. All profits and losses pass through the business directly to the partners and each pays taxes on his or her share of the profits or deducts his or her share of the losses on individual income tax returns. The portion paid will depend on the agreement between the partners.
Distributive Shares
According to the IRS rule about distributive shares, even if partners need to leave profits in the partnership for the purpose of covering future expenses or expanding the business, each partner still will owe income tax on his or her rightful share of that money. This means that you pay tax on money you may never have received from the partnership.
Each partner should set aside enough money to pay taxes on his or her share of annual profit because there’s no employer to withhold income taxes. Like many small business owners or independent contractors, partners must estimate the amount of tax owed for the year and make quarterly payments to the IRS and the appropriate state tax agency.
Self-Employment Taxes
Much like the payroll taxes that employees pay, self-employment taxes are required on all partnership profits. You can deduct what would be the employer portion (half) of the social security and medicare expenses on your 1040 personal tax return.
It’s important to know that there is no way around this when you enter into a partnership. Even without a partnership agreement, partners are still bound by state law. Partners must pay taxes on their share of the partnership’s profits, which is made up of total sales minus expenses, regardless of how much money actually is withdrawn from the business.
Business Expenses
But don’t worry, there is good news. Like all other business ventures, partners don’t need to pay taxes on most of the money the business spends on legitimate business expenses, which will be deducted from your business income. This can lower the profits you have to report to the IRS. Expenses such as start-up costs, travel outlays (including meals and entertainment), operating expenses, and product and advertising spending are acceptable.
When going into a partnership, make sure you know the accounting and tax implications of the partnerships actions, or work with an accountant who does.
