Taxation of Partnerships and Sole Proprietorships
We’ve lumped these two together because they’re treated very similarly from a tax point of view. Legally, a sole proprietorship is just you, sometimes operating under a different name (frequently called a “dba”, which is an abbreviation for “doing business as”). So, you could be Mike Smith doing business as “Mike’s Repairs.” In any case, you are that business, and that business is you as far as the law is concerned. DBA statements are generally filed with the clerk of the county in which you’re doing business so that, if somebody wants to sue “Mike’s Repairs,” they can find out what person “Mike’s Repairs” really is.
There are two main types of partnerships; a general partnership and a limited partnership. A general partnership is, in many ways, treated as a collection of sole proprietorships. All the partners are involved in the business, all can make decisions, and all are liable for the acts of that business. A limited partnership is a structure where one partner is actively involved and calls the shots (the general partner), while the others are usually silent and passive investors (the limited partners). In a limited partnership, the limited partner’s liability is generally limited to whatever they’ve invested, while the general partner is on the hook for all the legal liabilities of the business.
Partners and sole proprietorships are taxed on their share of the profits of the business annually, even if those profits are not paid out to the owners. Sole proprietors and partners actively involved in their business are also subject to self-employment tax in addition to income tax on their share(s) of the profits of the business. Individuals paying self-employment tax get a deduction for half of the self-employment tax paid when calculating their income tax, and also get a deduction for a percentage of their net profit when calculating self-employment tax. Also, children of sole proprietors under age 18 who work in the business and are paid wages are not subject to social security tax on those wages.
Partners and sole proprietorships can also deduct their share(s) of losses from the business, should they occur. Corporation shareholders generally cannot deduct these sort of losses. So, a new business organized as a partnership or sole proprietorship operating at a loss while it gets started can pass those losses through to the owners’ tax returns, where those losses can offset other ordinary income. The amount of the deductible losses is limited to the amount for which an owner is “at risk”; this usually means what an owner has invested and is personally “on the hook” for as regards business debt.
Partnerships are what’s called “pass-through entities”, because they pass their income through to their owners on an annual basis, rather than paying tax themselves. This is done in such a way that the character of the income in the hands of the owner is the same as it had been to the partnership. For example, capital gains which occurred at a partnership level are treated as capital gains by the partners. The character of most forms of income, losses, credits and deductions will be the same for most owners as it was for the partnership. So, when individual owners pay tax on their share of the qualifying dividends received by the partnership, they also get the special rate on qualifying dividends, passive income and loss as well as tax-exempt interest keep their characterization for the owners, while credits, investment income and similar items are all passed through as well.
Partnerships pass this income through to their partners according to their governing agreements. This agreement could stipulate, for example, that Partner A, while owning 50% of the partnership, is entitled to take 60% of the profits and 80% of the losses on his personal tax return until certain limits are reached. Partnerships can also “pay” their partners separately from their allocation of profits; these payments are called “guaranteed payments” and are subject to both income tax and, usually, self-employment tax. These provision allow for a lot of flexibility in the allocation of money, profits and losses, such as when a new business has investors who need to be paid off before the “sweet equity” partners get paid.
Finally, most partnerships and virtually all sole proprietorships must operate on a calendar year basis. A partnership can use a fiscal year only in certain limited circumstances, and must usually keep a certain amount of prepaid tax on deposit with the IRS.
With all that said, we are experts on handling partnership and sole proprietorship tax returns. Give us a call or shoot us an email any time!
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