If you ever considered setting up a partnership, then you must understand how partnerships are taxed – their taxation is rather odd.
First of all, you should know that partnerships do not pay federal income taxes. Instead, the individual partners pay income taxes on their shares of the partnership’s net income.*
For example, suppose that you hold a 50% share in a partnership that reports $1000 in business income. 50% of that business income ($500) would show up as taxable income on your own tax return . Here’s the interesting part: You must pay income taxes on the $500 of business income, even if you didn’t receive any cash from the partnership. You must pay income taxes on your share of partnership income regardless of whether you actually receive any cash from the partnership.
Another interesting aspect of partnership taxation is how deductions “pass through” to the individual partners. Just as partnerships don’t pay federal income taxes, so too, they can’t take advantage of deductions. Instead, different types of deductions recorded by the partnership are deducted by the individual partners on their own tax returns. For example, if that same partnership paid $200 in charity, then you, a 50% partner, could deduct $100 for charitable contributions on your own tax return.
Most obnoxious here is self-employment tax, currently 13.3% but due to return to 15.3% next year. Business income from a partnership is subject to both components of self-employment tax: Social Security and Medicare. Like all other partnership taxes, it is due from the partners, rather than the partnership, regardless of whether the partners received any cash from the partnership.
These tax provisions require careful planning. A partnership should plan to allow its partners with withdraw at least enough money each year to cover the taxes on their partnership income.
For more information, go to the IRS website.
*This is quite different from corporations, whose shareholders pay taxes on the dividends that they actually receive. Other facts for newbies: (1) Partnerships are separate from their partners. This means that a partnership can hold cash without distributing it to individual partners. (2) Furthermore, net income does not necessarily imply cash flow. A company can have net income without cash flow, and as I explain above, an individual can earn taxable income (and have to pay taxes on it) without actually receiving any cash.