A partnership is considered a pass-through entity. With this form of business the business does not pay the taxes, the business owners do. It is important for partners to understand the obligations of the business in the tax process and the obligation of the individual partners when it comes to taxes.
Partnership taxation is similar to that of sole proprietors, S corps, and LLC companies in the sense that they are pass through entities. With a pass through entity, the business owners pay the taxes, not the business. Even though the owners are responsible for paying the taxes, the business is still required to file an annual tax return. The annual tax return that is filed contains all the deductions and income information of the business, which is not reported on the individual tax returns of the owners.
Tax & Filing Obligation of Partnership
The actual partnership is consider a pass through entity. The partnership doesn't pay any federal or state taxes. The tax obligation is passed on to the partners through a K-1 statement. The partnership is still required to file an annual tax return every year. The tax form used for a partnership is IRS Form 1065, U.S. Partnership Return of Income. The partnership return will show all the business's sales, expenses, and other business deductions. Once the partnership tax return is complete, this information is used to create K-1 statements for the partners that are involved with the business. The K-1 statement will show each partners share of income or loss. The IRS will use this K-1 information to make sure that all of the individual partners actually reported their share of income on their individual tax returns.
In order to file as a partnership it is required that a federal tax ID number (FEIN) is received. This tax ID number must be supplied on IRS form 1065 and the K-1 statements when they are filed.
Tax & Filing Obligation of Partners
Partners are not considered employees of the company and they are not paid wages. Since they are not paid wages the company doesn't pay payroll taxes on the partners' income. Instead of being paid wages, the owners take out money from the company's profits through owner draws or distributions. These draws are shown on the company's balance sheet and not the P&L. Since they are not considered an expense, they are not deducted against company profits. Once the business tax return is complete, each partner's portion of the profits are computed on Schedule K-1. Schedule K-1 will show each partners share of the company's profits or loss, tax deductions and other tax items. The amount reported on the K-1 statement is reported on Schedule E of the partner's individual tax return.
Since each partner is not paid wages by the company and they pay themselves through owner draws or distributions, it is required that they pay self-employment taxes. Self-employment taxes are a combination of Social Security taxes and Medicare taxes. Also, it is required that the partners make quarterly estimated tax payments using Form 1040-ES to report and pay the taxes. These estimated taxes will cover both income and self-employment taxes owed. It is also required that the partners pay their state estimated tax payments if they live in a state with income taxes. It is important to pay enough estimated taxes on a quarterly basis to avoid the IRS underpayment penalty.
Since the partnership itself is considered a flow-through entity, the partners must agree on how the income of the partnership will be allocated between them. It is required that the allocation among the partners reflect the economic reality of the partnership. When a partnership is setup the taxation guidelines must be understood by each participating partner in order for them to individually pay the required amount of taxes (different guidelines apply to silent partners).