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Small business partnerships

Business partnerships consists of two or more people working together to make a profit. There are two types of business partnerships, general and limited. While there are differences regarding partnership liability and management rights, they are generally treated the same for federal tax purposes.

Business partnerships are "pass through" entities (sometimes also called "reporting" entities) in that they do not pay taxes themselves. They calculate their income and expenses on a partnership tax return (Form 1065) and then "pass" the results through to the partners in proportion to their partnership rights to share profits (usually the same as percent ownership). Each partner then reports his or her share on his or her personal income tax return.

• What are the tax advantages of a partnership?

• What are the tax disadvantages of a partnership?
  

What are the tax advantages of a partnership?

Small business partnerships do not face double taxation, because partnerships pass their net profits through to the partners without first being taxed.

Partnerships have the ability to make special allocations. A special allocation gives a partner more than his or her share of an item such as depreciation. Though the rules are complex, and an allocation has to have "substantial economic effect" (simply put, it can't be done just for tax reasons), a special allocation is a valuable planning tool for business partnerships. But it is complex, and expert advice is recommended.

Generally, property can be transferred into and out of a partnership tax free, while contributions to a corporation are often taxable, and property distributions from a corporation are often subject to tax.

Partnership liquidations are not subject to two levels of tax. C corporation liquidations are.

What are the tax disadvantages of a partnership?

Losses can be taken by the partners, but they are more limited than in a sole proprietorship.

Certain expenses such as charitable contributions cannot be deducted by the partnership, but are passed through to the partners. Why is this important? Because not deducting an expense at the partnership level raises the amount of partnership profit that is attributed to each partner. This means that there is more income tax liability - unless the partner can deduct the expense on his or her tax return.

Greater partnership profit can also mean more "self employment tax" for partners who are active in the partnership. Self employment tax is not reduced, even if the partner can deduct the expense because it is figured on the business partnership profit.