What is a partnership, and how is it taxed?
A partnership is a flow-through entity, which means that the partnership’s income passes to the partners. Partnerships issue each partner a K-1 each year, and the income reported is taxed on each partner’s individual return (Form 1040). Most income from the K-1 will be reported on Schedule E.
As a general rule, partnership income is subject to income tax at the partner’s income tax rate and self-employment tax at approximately 15%. Tax returns for partnerships are due by March 15 in order to give partners time to file their Form 1040s by April 15. If the partnership needs extra time to file, a 6-month extension is available. (This does not, however, extend the time they have to pay.) Because the income is taxed on the partners’ return, a partnership generally will not owe federal tax. State tax liability, however, depends on the state tax law, so it’s possible that the partnership will owe state tax.
How are the members of a partnership taxed?
If a partnership has W-2 employees, then the partners themselves cannot be employees of the partnership. Instead, partners can take guaranteed payments from a partnership, which are deductible to the partnership and subject to self-employment tax for the partner. To find the basis of the partner’s investment balance (which cannot be lower than zero), add the partner’s initial contribution, income from the partnership, additional contributions, and increases to recourse loans, and then subtract the partner’s losses, distributions, and reductions to resource loans.
A limited partner generally has no obligation to contribute additional capital to the partnership and, therefore, neither bears economic risk of loss in the partnership’s recourse liabilities nor shares in those liabilities for the purpose of calculating basis. If not an active participant, a limited partner may not owe self-employment tax on partnership income; however, they would then have little or no power in decision making. If a limited partner becomes too involved, then their income could be subject to self-employment tax.
Contributions to and distributions from partnerships are generally tax-free events, as income is taxed each year as it is earned through the K-1. Distributions that exceed the basis are taxable to the receiving partner. When discussing the contribution of assets, the partnership will generally carry the same basis and holding period as the partner. A partnership can own property and will have a separate depreciation schedule from its owners.
Farm Businesses as Partnerships
Due to Farm Service Agency (FSA) benefits, partnership is often the preferred entity structure for farmers. Be aware, however, that partnerships do not provide the same legal liability protection as an LLC or a corporation. An LLC can elect to be taxed as a partnership if it has two or more owners. To qualify as a partnership, the entity must have at least two owners—which could be a husband and wife who own a partnership as two separate taxpayers.
For more information about partnerships and help determining whether partnership is the most beneficial entity structure for your farm, contact the AgriSolutions tax department. AgriSolutions provides ag-specific financial consulting, training, and management for family farms. View our case studies to learn how we’ve helped farm owners like you.
Disclaimer – Descriptions provided in this article are presented as generalities. There are many factors not listed above that may impact your tax positions. This article should not be considered legal or tax advice. For advice on a specific transaction, please contact the AgriSolutions Tax department at firstname.lastname@example.org .