What are the important federal income tax issues if you choose to operate your business as a partnership with multiple partners? Good question.
We will supply some answers here.
Before we get into the weeds, one important thing to know is that limited liability companies (LLCs) with multiple members—that is, owners—are classified as partnerships for federal income tax purposes unless you elect to treat the LLC as a corporation.
The partnership tax considerations that we will cover here generally apply equally to LLCs. So, when you see “partnership” and “partner,” you can substitute “LLC” and “member,” respectively.
Partnership Taxation Basics
The generally favorable partnership federal income tax rules are a common reason for choosing to operate as a partnership with multiple partners instead of as a corporation with multiple shareholders. The most important partnership tax rules can be summarized as follows.
You Get Pass-Through Taxation
Your share of partnership taxable income items, gains, deductions, losses, and credits are passed through to your personal return. You then pay taxes at the personal level. Ditto for the other partners.
So, you don’t have to worry about the double taxation issue that can potentially haunt C corporations.
You also don’t have to worry about the tax-law restrictions that can haunt S corporations—for example, shareholders can only be U.S. citizens; U.S. residents; and certain estates, trusts, and tax-exempt entities; and you can have only one class of stock.
You Can Deduct Partnership Losses (within Limits)
You can deduct partnership losses passed through to you on your personal return, subject to various limitations—which can include the passive loss rules, the at-risk rules, the excess business loss disallowance rule, and the partnership interest basis limitation rule. There’s a good chance the limitations won’t apply to you or the other partners.
You May Be Eligible for the QBI Deduction
Through 2025, the qualified business income (QBI) deduction is potentially available to individual partners. The deduction can be up to 20 percent of QBI passed through to you from a partnership.
Higher levels of personal income can reduce and even eliminate the QBI deduction.
The QBI deduction will expire at the end of 2025 unless Congress extends it.
You Get Basis from Partnership Debts
Your tax basis in your partnership interest is increased by your share of partnership liabilities. The additional tax basis from partnership debts allows you to deduct partnership pass-through losses in excess of your investment in the partnership (subject to the potential limitations mentioned earlier).
The additional tax basis from partnership debts also allows you to receive cash distributions in excess of your investment in the partnership.
You Get Basis Step-Up for Purchased Interests
If you purchase partnership interest from another partner, you can step up the tax basis of your share of partnership assets, which minimizes taxes for you when the partnership sells those assets or converts them to cash. This privilege is available if the partnership makes a Section 754 election or already has one in effect.
You Can Make Tax-Free Asset Transfers with the Partnership
You have flexibility to make federal-income-tax-free transfers of assets (including cash) between yourself and the partnership.
If you operate as an Idaho S or a C corporation, you have no such flexibility for transfers of assets between shareholders and the corporation. Transfers of appreciated assets will trigger taxable gains.
You Can Make Special Tax Allocations
Partnerships can make special (disproportionate) allocations of taxable income, tax losses, and other tax items among the partners.
For example, a high-tax-bracket partner with a 20 percent partnership interest could be allocated 80 percent of partnership depreciation deductions, while lower-tax-bracket partners who own 80 percent of the interest are allocated only 20 percent of the depreciation deductions.
Later on, the high-bracket partner can be allocated more of the partnership’s gains from selling depreciable assets to compensate for the earlier special allocation of depreciation.
Partnership Taxation Disadvantages and Complications
Partnership taxation is not all good stuff. There are a few important disadvantages and complications to consider.
Exposure to Self-Employment Tax
You and other partners who are individuals may owe self-employment tax—consisting of the 12.4 percent Social Security tax component and the 2.9 percent Medicare tax component—on some, most, or all of the income passed through to you by the partnership.
At higher income levels, you may also owe the 0.9 percent additional Medicare tax.
Specifically, for 2022, the self-employment tax rate is 15.3 percent on the first $147,000 of net self-employment income, including net self-employment income passed through to you from a partnership.
That 15.3 percent self-employment tax rate comprises
Above the $147,000 threshold, the Social Security tax component goes away for 2022, but the 2.9 percent Medicare tax continues, before rising to 3.8 percent at higher self-employment income levels ($200,000 if you’re unmarried or $250,000 if you’re a married joint-filer).
The 3.8 percent rate consists of the “regular” 2.9 percent Medicare tax plus the 0.9 percent additional Medicare tax on higher earners.
|Example. Say your share of the net business income from a partnership in 2022 is $200,000. You have no other income that would be subject to the self-employment tax.
Multiply $200,000 by 0.9235. The result is $184,700, and that’s the net self-employment income amount that’s subject to the self-employment tax. Your self-employment tax bill will be a whopping $23,584 [($147,000 x 12.4 percent) + ($184,700 x 2.9 percent)].
Sadly, in calculating your net self-employment income, you don’t get to deduct contributions to a self-employed retirement plan, the deduction for a portion of your self-employment tax, or the deduction for self-employed health insurance premiums.
In contrast, if you run your business as an S or a C corporation, Social Security and Medicare taxes (in the form of the FICA tax) hit only amounts paid out as salary to you and the other owners. This can be an important factor in favor of operating as a corporation.
Key point. As explained later, limited partners have a self-employment tax advantage. General partners don’t.
Complicated Section 704(c) Tax Allocation Rules
If you and all the other partners simply contribute cash to form the partnership, and the partnership then uses the money to buy stuff, making tax allocations is pretty simple.
But if some partners contribute cash and others contribute assets with fair market values that differ from their tax bases, the Section 704(c) rules come into play. Long story short, these rules require the partnership to make tax allocations that take into account the difference between tax basis and the fair market value.
In the simplest example, say you contribute raw land with a fair market value of $1 million and tax basis of only $250,000. If the land is later sold by the partnership for more than $250,000, the first $750,000 of taxable gain must be allocated to you under the Section 704(c) rules.
These rules can also come into play in much more complicated ways. We can’t do the complications here without turning this article into a whole book.
Tricky Disguised Sale Rules
The partnership disguised sale rules represent one of the most complicated subjects in partnership taxation. They can cause what appear to be non-taxable transfers of assets between partners and partnerships to be treated as partially or wholly taxable sales.
For example, if you contribute property to the partnership and then receive a cash distribution, that can potentially be treated as a wholly or partially taxable sale of the property to the partnership, depending on the size of the distribution and how closely it occurs in time to the property contribution.
Disguised sales can potentially take any of the following forms:
Bottom line. Advance planning can often prevent unexpected and adverse tax outcomes under the disguised sale rules.
Unfavorable Fringe Benefit Tax Rules
Compared to C corporations, partnerships cannot provide as many tax-free fringe benefits to their owners. This factor favors operating as an Idaho C corporation, but it’s usually not an important factor.
The Limited Partnership Option
Limited partnerships are obviously treated as partnerships for federal income tax purposes, with the generally favorable partnership taxation rules explained earlier.
Limited partners generally are not exposed to liabilities related to the partnership or its operations. So, you generally cannot lose more than what you’ve invested in a limited partnership—unless you guarantee partnership debt.
So far, so good. But you must also consider the following disadvantages for limited partners.
Limited Partners Usually Get No Basis from Partnership Liabilities
If you are a limited partner, you will not get any additional tax basis in your partnership interest unless you make loans to the partnership or guarantee some partnership debt. That’s because you are not personally liable for other partnership debts, so you cannot be allocated any additional basis from them.
Limited Partners Can Lose Their Liability Protection
Under applicable state law, limited partners can potentially lose their limited liability protection by becoming too actively involved in managing the limited partnership. Therefore, limited partnerships may be unsuitable for activities where all or most of the owners are heavily involved in the business.
Key point. No type of entity (including a limited partnership in which you are a limited partner) will protect your personal assets from exposure to liabilities related to your own professional malpractice or your own tortious acts.
Tortious acts are wrongful deeds other than by breach of contract—such as negligent operation of a motor vehicle resulting in property damage or injuries. The issue of liability exposure is a matter of state law, and you should seek advice from a competent business attorney for full details.
You Need a General Partner
Every limited partnership must have at least one general partner, and that general partner is theoretically exposed without limitation to all recourse liabilities of the partnership.
But the general partner can be an LLC or an S corporation owned by one or more of the limited partners. That way, the general partner entity can lose its shirt to partnership liabilities, but the economic cost is limited to the general partner entity’s capitalization.
The limited partners (including those who own the general partner entity and effectively run the partnership) are protected against losing more than what was invested in their limited partnership interests. Still, having to set up a separate entity to function as the general partner is an unwelcome complication.
On the Plus Side: Limited Partners Have a Self-Employment Tax Advantage
Thanks to a long-standing special self-employment tax rule for limited partners, a limited partner who is an individual includes in his or her self-employment income only guaranteed payments from the partnership for services rendered to the partnership.
Guaranteed payments are payments that are determined without regard to the partnership’s income.
They are often called “partner salaries.” The special self-employment tax rule for limited partners is beneficial because limited partners usually don’t receive any guaranteed payments for services (partner salaries), and therefore they usually don’t owe self-employment tax on their shares of partnership income.
In contrast, if you are a general partner, you must include your share of the partnership’s net income from business activities in your self-employment income. Therefore, general partners usually owe self-employment tax on their shares of net partnership income.
Bottom line. The self-employment tax issue dictates in favor of operating as a limited partnership instead of as a general partnership, when possible.
The General Partnership Option Is Usually a Bad Idea
Partners of a general partnership are personally liable (without limitation) for all debts and obligations of the partnership.
The liability of general partners is “joint and several” in nature.
That means any one of the general partners can potentially be forced to make good on all partnership liabilities. That partner may be able to seek reimbursement from the partnership for payments in excess of his or her share of liabilities. But that depends on the ability of the other partners to contribute funds to allow the partnership to make such a reimbursement.
Note that general partners are jointly and severally liable for partnership liabilities related to the tortious acts and professional errors and omissions of the other general partners and the partnership’s employees.
In addition, general partners are personally liable for their own tortious acts and professional errors and omissions.
Finally, under applicable state law, each general partner usually has the power to act as an agent of the partnership and enter into contracts that are legally binding on the partnership (and ultimately on the other partners).
For example, a partner can enter into a lease arrangement that is legally binding on the partnership. For this reason, it is critical that the partners have a high degree of trust in one another. If that is not the case, a general partnership is inadvisable.
The Partnership Agreement
Since your partnership will have multiple partners, multiple issues can come into play. You’ll need a carefully drafted partnership agreement to handle potential issues even if you don’t expect them to arise. For instance, you may want to include
The Multi-Member LLC Option
A multi-member LLC that’s treated as a partnership for federal income tax purposes may be the best entity alternative for businesses with several owners.
You get the generally favorable partnership taxation rules, plus operating as an Idaho LLC generally protects your personal assets from exposure to business-related liabilities. Such exposure can include everything from a lawsuit filed by the Federal Express guy who slips on your ice-covered steps to the seemingly endless variety of liabilities that can be caused by the actions or inactions of employees.
Arguably, some Idaho LLC members can qualify for the aforementioned limited partner exception to the self-employment tax rules. But that’s a whole other story that we won’t go into here.
Key point. Under some state laws and/or applicable professional standards (such as state bar association rules), LLCs may be prohibited from operating certain types of professional practices.
Quick and Dirty Comparison of Partnership Taxation to Idaho S Corporation Taxation
Like partnerships and multi-member LLCs that are treated as partnerships for federal income tax purposes, S corporations offer the advantage of pass-through taxation.
But the partnership taxation rules (which apply equally to multi-member LLCs treated as partnerships for tax purposes) are more favorable and more flexible.
For instance, if you are an S corporation shareholder, you don’t get any tax-loss-deduction basis from S corporation debts, except for loans that you make to the corporation. There is no step-up in the basis of S corporation assets if you buy shares from another shareholder. And you have limited flexibility to engage in tax-free transactions with the S corporation.
Specifically, when assets are transferred from an Idaho S corporation to a shareholder, you must determine whether the transaction is shareholder-employee compensation, subject to employment taxes; a distribution; or something else.
Distributions of property (other than cash) generally are treated as if the Idaho corporation sold the property to the recipient shareholder for fair market value. The corporation must recognize taxable gain to the extent the property’s fair market value exceeds its basis and must allocate the gain to the shareholders in proportion to their stock ownership percentages.
Finally, you cannot disproportionately benefit from special tax allocations, because all Idaho S corporation tax items must be allocated to shareholders strictly in proportion to their stock ownership percentages.14
On the plus side, if you are both an S corporation shareholder and an employee of the corporation, the dreaded Social Security and Medicare taxes (in the form of the FICA tax) hit only your salary compensation, assuming it’s not unreasonably low. Cash distributions from the S corporation to you, which you might call “dividends,” are exempt from Social Security and Medicare taxes.
Don’t Overlook the State Tax Factor
Sometimes the decision about whether to operate as a partnership, an Idaho LLC, an S corporation, or a C corporation is based on state tax issues. What works for me might not work for you if you live in another state.
For example, LLCs are generally attractive from federal income tax and liability protection perspectives. But Texas LLCs are subject to the state’s franchise tax, which is similar to a corporate income tax. Partnerships are not subject to the Texas franchise tax.
In Colorado, meanwhile, Idaho partnerships and LLCs are not subject to any entity-level state income or franchise tax.
So, it depends. Do your state tax homework before making a final choice of how to operate your venture.