If you’re running a business or investment activities with others, you’ve likely heard of partnerships or multi-member LLCs (limited liability companies). These business structures are popular because of the federal tax benefits they offer, like pass-through taxation. However, they also come with some complex tax rules you need to consider.
What Are Governing Documents?
In a partnership, the partnership agreement is the key document that outlines the roles and responsibilities of each partner. Similarly, in an LLC, the operating agreement does the same for its members. These documents are crucial because they should include important tax-related information. Here are some things to keep in mind when creating them.
Understanding Partnership Taxes
In a partnership, the business itself doesn’t pay federal income taxes. Instead, the profits and losses are “passed through” to the partners, who then report them on their personal tax returns. Each partner gets a Schedule K-1 form every year, which shows their share of the business’s tax numbers.
Partners can deduct any losses that are passed through to them, but there are some limits, like passive loss rules, which might apply.
Special Tax Allocations
Partnerships have the flexibility to allocate profits, losses, deductions, or gains unevenly among partners. This is called a “special tax allocation.” For example, one partner might get 80% of the depreciation deductions (which can lower their taxable income) even though they only own 50% of the business. However, there are strict IRS rules to follow if you want to make these special allocations.
Distributions to Cover Taxes
Partners may owe taxes on their share of the partnership’s income, even if they don’t receive any cash from the business. To help with this, many partnership agreements include a rule that the business must make cash distributions to help partners cover their tax bills. These distributions are often calculated based on each partner’s specific tax situation.
For example, the agreement might say that the business will distribute enough cash to cover 15% or 20% of each partner’s share of long-term capital gains. These payments might be made in early April to help partners pay their taxes from the previous year.
Get Help with Tax Issues
When setting up a partnership or LLC, it’s important to address these tax issues in your agreement. Feel free to reach out to us for help in the process! Padgett is here for you.