Federal Income Tax when Your Small Business is a Partnership

When your small business is set up as a partnership, the partnership itself does not pay federal income taxes. Instead, the profit or loss from the partnership is passed on to the partners. The partners then report their share of the partnership income or loss on their income tax returns.

Even though the partnership does not pay tax, an information return,Form 1065, must be filed for the partnership. On this form you report all the income and expenses of the partnership operations, gains and losses, tax deductions and credits, a partnership balance sheet at the beginning and end of the year per the partnership books, a reconciliation of income or loss per the books to the income or loss for tax purposes, an analysis of the partners' capital accounts, and other information related to the partnership.

Then each partner's share of the partnership net income or loss, deductions, and credits is reported on Schedule K-1. Schedule K-1 also includes a breakdown of the partner's share of liabilities at year end and an analysis of the partner's capital account. A separate Schedule K-1 must be issued to each partner.

A limited liability company (LLC) is not recognized as a separate type of entity for federal income tax purposes and must file as a corporation, partnership, or sole proprietorship. If the LLC is considered a partnership, it must file Form 1065 and Schedules K-1 for each member of the LLC.

Form 1065 must be filed by the 15th of the fourth month after the end of the partnership's tax year (April 15th if you use the calendar year). In order for you and your partners to file your individual income tax returns, you may want to complete the partnership return and the Schedules K-1 earlier.

As a partner, your income from the partnership is not considered a salary or wages for federal income tax purposes. You would report your share of income from the partnership in Part II of Schedule E, Supplemental Income and Loss, of Form 1040. If the partnership has a loss, you may be subject to the at-risk and passive activity loss limitations, depending on how much you have invested and how you participate in the partnership. These limitations could affect the amount of your share of the partnership's loss that you can deduct on your tax return.

In addition to federal income tax on your share of the partnership's earnings, you may also be subject to self-employment tax, which is the equivalent of the social security and Medicare taxes on salaries and wages. If you are a general partner you would normally be subject to self-employment tax on your share of the partnership's net earnings from operations. If you are a limited partner you would pay self-employment tax on payments you receive for services you actually render to the partnership. These amounts are reported on Schedule K-1.

If you expect your small business partnership to be profitable for the year, you should project your share of partnership earnings and make estimated tax payments during the year to cover your federal income tax and self-employment tax liability. This will avoid having to make a substantial payment when you file your annual income tax return and a potential penalty for underpayment of tax.

Sources:
Form 1065, U.S. Return of Partnership Income, IRS
Instructions for Form 1065, IRS
Instructions for Schedule E (Form 1040), IRS
Instructions for Schedule SE (Form 1040), IRS
Limited Liability Company (LLC), IRS
Partnerships, IRS
Penalty for Underpayment of Estimated Tax, IRS
Schedule E, Supplemental Income and Loss, IRS
Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc., IRS