If a group of two or more people carry on any sort of business without becoming incorporated, this is considered to be a partnership. An entity with these characteristics cannot be termed a partnership if it is an insurance company, a real estate investment trust, a tax-exempt organization, or is owned by a local or regional government.
If the partnership takes the form of a general partnership, in which all of the partners are active, then each partner is liable for the negligence of any and all other partners, as well as for the liabilities of the partnership. To get around this significant problem, it is possible to create a limited partnership, in which limited partners are only liable for the funds they have invested as capital in the business, while a general partner, who operates the partnership on their behalf, is liable for all activities and losses. A limited partnership is subject to the IRS regulations governing passive activities, which keeps the partnership from recognizing passive losses that exceed the income derived from any passive activities. Also, if the partnership has losses so large that they exceed the capital contributions of the partners (e.g., the amount they have at risk in the business), then IRS rules will prohibit the recognition of any losses that exceed the amount that the partners have at risk.
A variation on the partnership concept is a limited liability company; this is an entity that files articles of incorporation, and whose members are not personally liable for the organization’s liabilities.
A partnership is governed by a partnership agreement, which specifies how the ownership percentages of the partnership are determined, and under what circumstances and payment plans partners can be bought out by the remaining partners. The partnership agreement can specify preferential returns for some of the partners. If the partnership agreement is not clear about how income is to be distributed, then it will be based on the partners’ relative contributions to the partnership. If there are variations in the proportional share of each partner during the tax year, perhaps due to additional contributions to the partnership, then the average share of each partner must be calculated and used to determine the proportional distribution of income amongst the partners at the end of the tax year; however, alternate arrangements for preferential returns, if specified in the partnership agreement, will override this calculation.
Every partnership must file an information return on Form 1065 that specifies its taxable income at the end of the year, as well as the identity of each partner and the amount of the income that is attributable to each one. The partnership must issue Schedule K-1 of the Form 1065 to all partners on a timely basis, or else a penalty will be charged against the partnership for each K-1 form not issued. The K-1 form is used by each partner as a source of income or loss from the business that is then included in his or her personal income tax return. If the partnership does not file a tax return in a timely manner, then it can be assessed a penalty of $50 per partner for each month in which the return is late, up to a maximum of five months.
Even if the profits from a partnership are not distributed to its partners, the profits are still taxable income to the partners. This generally results in a minimum distribution to the partners each year that allows them to pay their taxes, and which also keeps much money from accumulating within the business. If any funds are retained in the business rather than being distributed, they increase the capital contribution of the partners for tax purposes.
If a partnership experiences a loss, the share distributed to each partner will only be allowable to the extent that it offsets the adjusted basis in each partner’s partnership interest. If the amount of the loss exceeds the adjusted basis, then it cannot be deducted in that year, but may be carried forward for potential offsets against future increases in the interests of the partners. This principle is based on the concept that a partner cannot lose more than his or her total interest in the partnership.
Partners may have to make estimated tax payments during the course of the tax year as a result of income from a partnership. If so, the estimated tax must, at a minimum, be the smaller of 90% of the expected partnership income for the year, or 100% of the total tax paid in the preceding year. Also, partners are not counted as employees of a partnership, and so must pay a self-employment tax.
A partnership can make a number of elections regarding the reporting of income. For example, it can choose between the accounting, cash, and hybrid methods of accounting. It can also choose between two types of MACRS depreciation, various types of revenue recognition, and different approaches for recognizing organizational expenses. These issues are dealt with throughout this chapter. The main point is that the accounting methodology choices available to a partnership are the same as those available to a corporation.
If a partner contributes money to a partnership, followed by a distribution to the partner from the partnership, the two transactions will be netted and treated as a sale of property, especially if the contribution is contingent upon the later distribution, and if the partner’s right to the distribution is not impacted by the success of partnership operations. However, if the contribution and later distribution occur more than two years apart, then it is presumed that the transactions are separate and unrelated.
Distributions can be made to partners up to the amount of their adjusted basis in the company. The partnership will not recognize any gain or loss as a result of a distribution to its partners, since this is a flow-through of accumulated capital to them. If a distribution of property is made to the partners, they will not recognize a gain or loss on the transaction until they later dispose of it.