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:
- Pass-through taxation.
- You can deduct partnership losses (within limits).
- You may be eligible for the Section 199A tax deduction.
- Basis from partnership debts.
- You get basis step-up for purchased interests.
- Tax-free asset transfers with the partnership that you can make.
- special tax allocations you can make.
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
- Complicated Section 704(c) tax allocation rules
- Tricky disguised sale rules
- Unfavorable fringe benefit tax rules
The Limited Partnership Option
Limited partnerships are obviously treated as partnerships for federal income tax purposes, with the generally favorable partnership taxation rules mentioned above.
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.
- Limited partners can lose their liability protection.
- You need a general partner.
On the plus side, limited partners have a self-employment tax advantage.
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
- a partners interest buy-sell agreement to cover partner exits;
- a non-compete agreement (for obvious reasons);
- an explanation of how tax allocations will be calculated in compliance with IRS regulations;
- an explanation of how distributions will be calculated and when they will be paid (for instance, you may want to call for cash distributions to be made annually in early April to cover partners’ tax liabilities from their shares of income for the previous year);
- guidelines for how the divorce, bankruptcy, or death of a partner will be handled;
- and so on.
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.
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 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.
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.
Don’t Overlook the State Tax Factor
Sometimes the decision about whether to operate as a partnership, an 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, 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.
Takeaways
If you operate your business as a partnership, or as an LLC treated as a partnership for tax purposes, you and the other owners can benefit from the generally favorable partnership federal income tax rules explained in this article.
But applying those rules can get complicated. You will probably need professional assistance to comply and to avoid traps for the unwary that Congress has laid out for you.
Finally, operating as an S corporation can be a way to get pass-through taxation while mitigating your exposure to the dreaded self-employment tax. But S corporations have tax-law limitations that can be deal-breakers.
While you are now pretty well informed on the federal income tax aspects of operating as a partnership, or as an LLC that’s treated as a partnership for tax purposes, we recommend seeking professional advice before deciding what to do with a significant venture.
If you would like to discuss partnerships or LLCs, please call me on my direct line at 509-543-7600 or send a request HERE.
May 2022
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