A general partnership is a type of business entity. It must consist of at least two partners, though there is no maximum limit on the number of partners in a partnership. Because it is a pass-through entity, the partnership does not pay income tax. Rather, the partners report their share of partnership income on their personal tax returns. State law and your partnership agreement will govern the partnership. Your partnership agreement should contain, among other things, each partner’s share in management, profits, and losses. Indeed, the agreement can contain anything that is deemed appropriate by the partners and, of course, not prohibited by law. Absent such an agreement, or in cases where the agreement fails to address an issue, your state will dictate how the partnership is to operate. Your state’s version of the Uniform Partnership Act (UPA) will then control.
When can it be used?
A general partnership must have at least two partners, both of whom will carry on a business-for-profit as co-owners.
Strengths
Relatively Simple and Inexpensive to Create and Operate
Compared to a corporation, a general partnership is inexpensive and simple to create and maintain. No formal documents need be filed with the state. A partnership generally exists when at least two parties (individuals or entities) conduct a business for profit. Though not required, you should probably create a written partnership agreement to tailor the partnership to your needs. Otherwise, your state’s Uniform Partnership Act (UPA) will control the operations of your partnership.
Example: Ken, a general partner, intended to have only a few partners participate in management. However, because he failed to provide for such an arrangement in the written partnership agreement, the state’s default rule applied and all partners shared in management equally.
No Limit on the Number and Type of Partners
A partnership is unlimited in the number and type of partners it may have. In addition, a partnership may have other business entities (such as S corporations) as partners. Contrast this to an S corporation, which is limited to 100 shareholders meeting eligibility criteria.
Flexible in Sharing Profits and Control
A partnership can create ownership interests that would provide preferential treatment when profits are distributed to the partners or that would disallow participation in management. A partnership can thereby regulate the sharing of profits and control, unlike an S corporation, which is relatively inflexible in this regard.
Profits Taxed Only Once
A partnership is not assessed an entity level tax. Only the partners pay a tax on partnership profits. Therefore, a partnership is not subject to the double tax commonly associated with a C corporation. The partnership must, however, file an “informational” return with the IRS. Certain publicly traded partnerships are taxed like C corporations rather than as partnerships.
Example: For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. In an attempt to mitigate some of the burden of double taxation, various pieces of legislation provide that dividends received by an individual shareholder from domestic corporations and qualified foreign corporations are taxed at the rates that apply to capital gains. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains, and established new rates for higher-income taxpayers. Capital gains and qualified dividends are now generally taxed at 0% for taxpayers in the 10% and 15% tax brackets; at 15% for taxpayers in the 25% to 35% tax brackets; and at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.
Partnership Interests Can be Freely “Assigned”
Absent a contrary provision in the partnership agreement, or the objection of a partner, a partner can assign his or her partnership interests to another without restriction. An assignment, in contrast to outright sale of the entire interest, is only the transfer of the economic interest. The transferee generally gains only the right to receive profits or deduct losses. You can restrict a partner’s right to assign his or her partnership interest by including a restrictive provision in the written partnership agreement. However, such provisions do not restrict the statutory rights of creditors. The interest of any partner is subject to attachment.
Partners Can Deduct Losses and Have Them “Specially Allocable”
Partners can deduct the losses of the partnership on their personal tax returns. Most significant, a partner can have deductions “specially allocated” to him or her if such allocation has “substantial economic effect.” A disproportionate number of deductions would be given to the partner who pays the most taxes. The result: reduced tax liability. The method of allocation chosen must have a substantial economic effect for it to be valid. A partnership is a good idea if you anticipate large losses in the first several years of operation because it allows partners to reap immediate tax savings, quite like an S corporation. However, this feature gives the partnership an advantage over an S corporation:
Example: Ken is a 25 percent general partner. The partnership agreement allocates 50 percent of all losses to him so as to save him money in taxes. The partnership has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000) on his personal tax return. If Ken were an S corporation shareholder, his deduction would be limited to his percentage of ownership in the corporation, or 25 percent.
There are several significant restrictions on a partner’s ability to deduct losses. These restrictions include the passive loss and at-risk rules.
A Partner’s “Basis” is Increased by Partnership Liabilities
A partner can increase his or her basis in a partnership by, among other things, an amount equal to his or her proportionate share of the liabilities of the partnership. The higher the basis, the more losses that can be deducted. This feature gives the partnership an advantage over an S corporation:
technical Note: For purposes of determining whether a partnership liability is included in a partner’s basis, partnership liabilities are first allocated to those partners who bear an economic risk of loss with respect to a liability (called a recourse liability). In general, a partner bears an economic risk of loss with respect to a liability if the partner guarantees the liability, pledges property as security for the liability, or is required to make additional contributions to the partnership with respect to the liability. If no partner bears an economic risk of loss with respect to a liability (called a nonrecourse liability), the liability is generally allocated to all partners in the same proportion as they share profits.
Example 1: General partner Ken paid $1,000 for his 50 percent partnership interest. Thus, Ken’s basis in the partnership is $1,000. Subsequently, the partnership borrows $20,000 from a third party. Ken, who assumes partnership liabilities in proportion to his ownership interest, now has a basis of $11,000 ($1,000 + [$20,000/2]). (On the other hand, if Ken bears 100 percent of the economic risk of loss with respect to the $20,000 loan (perhaps Ken is required to pay the creditor if the partnership defaults), Ken could increase his basis to $21,000 ($1,000 + $20,000). However, if the other partners bear 100 percent of the economic risk of loss, Ken’s basis would remain at $1,000.)
While partnership basis may increase with increased liabilities allowing more losses to be deducted, basis will be subsequently reduced as liabilities are paid down or when the business is sold and liabilities are paid off.
Example 2: Assume the same facts as in the above example except that Ken is instead a 50 percent shareholder in an S corporation. Because S corporation shareholders cannot increase their basis by loans from third parties, Ken’s basis will remain at $1,000 despite the $20,000 loan to the S corporation.
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Old Basis
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Liabilities Added to Basis
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New Basis
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General Partner
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$1,000 +
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($20,000/2)
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= $11,000 (Basis reduces as liability is paid down)
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S Corporation Shareholder
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$1,000 +
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$0
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= $1,000
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Partner Can Contribute Appreciated Property Tax Free
You can contribute property to the partnership in exchange for a partnership interest. Such a contribution is tax free even if the property has appreciated in value since you purchased it. Such a transfer occurs when a partner exchanges real property (e.g., an office building to be used by the partnership) for an ownership interest in the partnership. However, there may be later consequences for a partner who contributes appreciated property, including possible recognition of gain.
Technical Note: When a partner contributes property to a partnership, allocations of income, deductions, and gain and loss must be made to the partner to reflect any difference between the property’s fair market value and its basis to the partnership. If the partnership distributes the property to another partner within seven years of its contribution, the contributing partner recognizes gain or loss on the distribution unless the contributing partner receives certain like-kind property. If contributed property has a built-in loss, the loss can only be allocated to the contributing partner and the basis in the property for other partners is limited to the fair market value of the property at the time of contribution.
Liquidation of a Partnership is Generally Tax Free to the Partners
Generally, when a partnership is liquidated (all of its assets distributed to the partners) the partnership is not taxed. However, a partner may recognize gain or loss to the extent money is distributed to the partner in liquidation of the partnership. An S corporation, by comparison, will be treated as if it sold the assets to the shareholders at fair market value (FMV).
Technical Note: A cash liquidation of a partnership is treated like a sale. A partner who is relieved of liability for a partnership debt is treated as receiving money. Items that generally generate ordinary income are taxed at ordinary income tax rates. For example, unrealized receivables and potential depreciation recapture are fully taxed as ordinary income, and gain or loss from inventory is ordinary income or loss. Otherwise, gain or loss is generally treated as capital gain or loss.
Tradeoffs
Partners are Personally Liable
Partners are personally liable for the partnership’s obligations as well as for most of the acts of other partners. For the limits on a partner’s liability for the acts of other partners. Liability of each partner may be minimized if the partnership has substantial assets—which would allow the partnership to borrow in a nonrecourse manner (creditors cannot sue partners for default, only partnership)—and if the partnership also has plenty of liability insurance. Also consider a limited partnership, which provides limited liability to certain limited partners, or an S corporation or limited liability company, each of which provide limited liability protection for all owners.
Each Partner can Typically “Bind” the Partnership
Absent agreement to the contrary, each partner has the authority to make the partnership responsible for his or her acts. Indeed, even if the written partnership agreement disallows a certain partner from having such authority, that partner can still bind the partnership by acts involving a third party who is unaware of the restriction on the partner’s authority. Have a written partnership agreement and provide for the rights and obligations of each partner as to one another as well as to third parties.
Partners Typically Cannot Sell Their Partnership Interest
Typically, a partner cannot sell (as opposed to assign) his or her partnership interest unless every partner consents to the transfer or the partnership agreement provides for such sale. Otherwise, the sale of a partner’s interest dissolves (ends) the partnership for “nontax purposes.” In other words, the partnership would no longer exist as far as state law was concerned, although the IRS could still tax it as a partnership. A partnership will, however, dissolve for “tax purposes” when one of two things occurs. The first is a cessation of business. This means that no portion of the business is conducted by any of the partners. The second scenario is when there are exchanges or sales (within any 12-month period) that total 50 percent or more of the total interest in the partnership profits and capital. If the partnership continues to operate after either of these events, it will be treated as if it were newly created. (Sale of 50 percent or more of the total interest in an electing large partnership—for more on this—will not cause the partnership to dissolve for tax purposes.) The remaining partners can nonetheless continue the business upon the withdrawal of a partner by placing a provision in the partnership agreement to that effect. Interests in certain publicly traded partnerships may be freely transferrable.
Partners Typically Have the Right to Withdraw from Partnership
Unless partners are restricted from doing so through a provision in the partnership agreement, a partner can typically withdraw from the partnership. Such an act will cause the partnership to dissolve for nontax purposes. One solution is to place a provision in the partnership agreement that restricts a partner from withdrawing or permits the remaining partners to continue the business whenever a partner ceases to be associated with the partnership. Though a partner may nonetheless withdraw, the partner might now be sued for violating the partnership agreement. If this seems harsh, think about this: A partner with no such incentive to remain could unilaterally dissolve the whole partnership against the wishes of all other partners merely by withdrawing.
Partnership Does Not Possess Continuity of Life
Unlike a corporation, a partnership does not “live” forever; the partnership lacks continuity of life. The withdrawal, death, bankruptcy, retirement, insanity, expulsion, or resignation of a partner dissolves the partnership for nontax purposes. The remaining partners can nonetheless continue the business upon the withdrawal of a partner by placing a provision in the partnership agreement to that effect.
Fringe Benefits are Taxable to Partner-Employee
Fringe benefits (e.g., bonuses, health insurance) are taxable to partner-employees. Contrast this with a C corporation, whose shareholders typically receive certain fringe benefits tax free.
How To Do It*
Consult an Attorney
You should consult an attorney experienced in business planning. Your attorney should be familiar with your state’s law, which will prescribe the requirements you will need to fulfill.
Carry on a Business-for-Profit with Two or More Co-Owners
Since a partnership is essentially two or more co-owners carrying on a business-for-profit, you must be sure that your business fits this description—that you share ownership and profits of your business with one or more individuals (or business entities).
Create a Written Partnership Agreement
Though not required, it is wise to create a written partnership agreement. In it you should dictate, among other things, how the partnership is to operate and in what manner profits and losses and management are to be shared among the partners.
Your Two-Member Unincorporated Entity is a Partnership by Default
Your unincorporated organization is automatically classified as a partnership if it has at least two members, unless it files with the IRS to be classified as an association taxable as a corporation.
*Checklist is not exhaustive.
Tax Considerations
Partners can Deduct Losses and have Them “Specially Allocated”
A partner can deduct partnership losses on his or her personal tax return. Indeed, a partner in a high tax bracket can have deductions specially allocated to him or her through the partnership agreement. The method of allocation chosen must have a substantial economic effect for it to be valid. This feature gives the partnership an advantage over an S corporation:
Example: Ken is a 25 percent general partner. The partnership agreement allocates 50 percent of all losses to him so as to save him some money in taxes. The partnership has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000) on his personal tax return. If Ken were an S corporation shareholder, his deduction would be limited to his percentage of ownership in the corporation—25 percent.
Restrictions are Placed on the Deductibility of Losses
A partner’s distributive share of losses is limited to the partner’s basis in the partnership. Losses that exceed a partner’s basis may be carried over and deducted in a subsequent year to the extent that the partner then has a basis greater than zero. There are several significant restrictions on a partner’s ability to deduct losses. These restrictions include the passive loss and at-risk rules.
Example: Assume the same facts as in the previous example: Ken is a 25 percent general partner. The partnership agreement allocates 50 percent of all losses to him so as to save him some money in taxes. The partnership has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000). However, because his basis (what Ken contributed to the partnership for his 25 percent interest, which included adjustments to reflect income, gain, loss, contributions, and deductions) is only $20,000, Ken can deduct that amount only and will have to carry the remaining $5,000 loss to subsequent years and deduct it when he has basis available to offset the loss.
Partners Taxed on Their Distributive Share of Income
A partner is taxed on his or her distributive share regardless of whether it is actually distributed to the partner. Note, though, if a partner’s share of income is retained by the partnership, his or her basis is increased dollar for dollar. This ensures that a partner is not taxed twice: once when the partnership earns income (that it retains), and again when the partner sells his or her partnership interest or when the income is distributed. Alternatively, as you may have guessed, when partnership income is distributed to a partner, a corresponding decrease in his or her basis is effected. A partnership, or any other pass-through entity for that matter, that anticipates retaining earnings for business purposes as opposed to distributing them should consider distributing enough income so that each partner can pay his or her tax liability.
Partner-Employees Subject to Self-Employment Tax
A partner may render services to the partnership. Payment for such services is called a guaranteed payment. Such payments, if for services rendered, are typically treated as ordinary income and subject to self-employment tax. Guaranteed payments could also include interest from a loan or return of capital. These payments would not be considered wages and not be subject to self-employment tax.
Wages to Partner-Employees Are Generally Considered Business Expenses by the Partnership
Wages paid to partners who render services to the partnership are called guaranteed payments. Such payments are considered business expenses of the partnership and are subtracted, like all other business expenses, from partnership earnings. The remainder is considered profit (or loss). This profit (or loss), reported by the partnership on the partnership informational return (Form 1065) and Schedule K-1, is either distributed to the partners or retained by the partnership. The partners then report their shares of profit (or loss), regardless of whether anything has actually been distributed, on their personal tax returns and pay tax thereupon (or deduct any loss).
Example: Ken and his sister Liz are 50 percent partners in a donut shop. Ken is paid $10,000 a year for donut making (guaranteed payment). Liz provides no services. Last year, the shop had $70,000 in income. Assuming no other business expenses, the amount to be distributed to all partners including Ken is $60,000 ($70,000 – Ken’s $10,000). Of this amount, Ken and Liz each get 50 percent, or $30,000. Ken pays income tax on $40,000 ($30,000 + $10,000 salary) and Liz pays taxes on $30,000.
If, however, a guaranteed payment is conditioned upon partnership profits, the payment is considered a portion of the partner’s distributive share and is therefore not treated as a business expense. Such payment would not be combined with other business expenses and would not get subtracted from partnership earnings.
Example: For his services, Ken has instead been promised his 50 percent partnership interest or $30,000, whichever is greater. The donut shop has $50,000 in income. Because 50 percent of $50,000 is $25,000, Ken gets $30,000. The amount that is considered a guaranteed payment is $5,000 ($30,000 – $25,000). Thus, Ken’s $30,000 represents his distributive share of partnership income ($25,000) as well as his salary (guaranteed payment of $5,000). The amount to be distributed to the other partners is $20,000 ($50,000 – Ken’s $30,000).
Fringe Benefits are Deductible by Partnership, Taxable to Partner-Employee
Fringe benefits are generally deductible by the partnership. However, like 2 percent S corporation shareholders, partners are taxed on the fringe benefits received. Contrast this with a C corporation, whose shareholders typically receive fringe benefits tax free.
Partner’s Basis is Increased by Partnership Liabilities
A partner’s basis in the partnership (what the partner paid for his or her share of the partnership) is increased by, among other things, the liabilities of the partnership. The more a partner’s basis is increased the more losses he or she can deduct.
Technical Note: For purposes of determining whether a partnership liability is included in a partner’s basis, partnership liabilities are first allocated to those partners who bear an economic risk of loss with respect to a liability (called a recourse liability). In general, a partner bears an economic risk of loss with respect to a liability if the partner guarantees the liability, pledges property as security for the liability, or is required to make additional contributions to the partnership with respect to the liability. If no partner bears an economic risk of loss with respect to a liability (called a nonrecourse liability), the liability is generally allocated to all partners in the same proportion as they share profits.
Example 1: General partner Ken paid $1,000 for his 50 percent partnership interest. Thus, Ken’s basis in the partnership is $1,000. Subsequently, the partnership borrows $20,000 from a third party. Ken, who assumes partnership liabilities in proportion to his ownership interest, now has a basis of $11,000 ($1,000 + [$20,000/2]). Ken can now deduct his share of partnership losses (which can be specially allocated) up to $11,000. (On the other hand, if Ken bears 100 percent of the economic risk of loss with respect to the $20,000 loan (perhaps Ken is required to pay the creditor if the partnership defaults), Ken could increase his basis to $21,000 ($1,000 + $20,000). However, if the other partners bear 100 percent of the economic risk of loss, Ken’s basis would remain at $1,000.)
While partnership basis may increase with increased liabilities, allowing more losses to be deducted, basis will be subsequently reduced as liabilities are paid down or when the business is sold and the liabilities are paid off.
Example 2: Assume the same facts as in the preceding example except that Ken is instead a 50 percent shareholder in an S corporation. Because S corporation shareholders cannot increase their basis by loans from third parties, Ken’s basis will remain at $1,000 despite the $20,000 loan to the S corporation. Therefore, Ken can deduct his pro rata share of losses up to $1,000.
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Old Basis
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Liabilities Added to Basis
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New Basis
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General Partner
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$1,000 +
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($20,000/2)
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= $11,000 (Basis reduces as liability is paid down)
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S Corporation Shareholder
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$1,000 +
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$0
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= $1,000
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Partner can Contribute Appreciated Property Tax Free
You can contribute property to the partnership in exchange for a partnership interest. Such a contribution is tax free even if the property has appreciated in value since you purchased it. An example of such a transfer is when a partner exchanges real property (an office building to be used by the partnership, for example) for an ownership interest in the partnership. However, there may be later consequences for a partner who contributes appreciated property, including possible recognition of gain.
Technical Note: When a partner contributes property to a partnership, allocations of income, deductions, and gain and loss must be made to the partner to reflect any difference between the property’s fair market value and its basis to the partnership. If the partnership distributes the property to another partner within seven years of its contribution, the contributing partner recognizes gain or loss on the distribution unless the contributing partner receives certain like-kind property. If contributed property has a built-in loss, the loss can only be allocated to the contributing partner and the basis in the property for other partners is limited to the fair market value of the property at the time of contribution.
Liquidation of a Partnership is Generally Tax Free to Partnership
Generally, when a partnership is liquidated, the partnership is not taxed. However, a partner may recognize gain or loss to the extent money is distributed to the partner in liquidation of the partnership. An S corporation, by comparison, will be treated as if it sold the assets to the shareholders at fair market value (FMV).
Technical Note: A cash liquidation of a partnership is treated like a sale. A partner who is relieved of liability for a partnership debt is treated as receiving money. Items that generally generate ordinary income are taxed at ordinary income tax rates. For example, unrealized receivables and potential depreciation recapture are fully taxed as ordinary income, and gain or loss from inventory is ordinary income or loss. Otherwise, gain or loss is generally treated as capital gain or loss.
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- Email: experts@henssler.com
- Phone: 770-429-9166
Disclosures: The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
