A partnership is a business entity that comes in two varieties: general and limited. The vast majority of small business partnerships are of the general type, where two or more people run a business and split the profits or losses. General partners contribute money or property along with their services to form the partnership, with each having a voice in the management of the business. Each partner can obligate the partnership to any contract, debt or other transaction within the scope of the company's operation. Each general partner is also personally responsible for all of the debts of the partnership; liability is not limited to the partner's proportionate interest in the partnership.

An exception to the rule of personal liability is the limited partnership. LPs, as they're commonly known, are typically used to raise money from passive investors (the limited partners), who will not be active in the running of the business. LPs have two categories of partners: one or more general partners, who are personally liable for all partnership obligations, and one or more limited partners who have no liability for partnership debts.

LPs may be required to register with the state agency that regulates securities (in most states this is the Secretary of State or Department of Corporations) and, in some cases, with the federal Securities and Exchange Commission (SEC) as well.

There is no federal partnership law; each state's individual law governs partnership formation and operation. However, all states have adopted the Uniform Partnership Act; partnership laws are therefore very similar from state to state.

From a tax standpoint, partners are much like sole proprietors; both report their share of the business's profits or losses on their personal tax return. And partners pay self-employment (Social Security and Medicare) tax on their share of the partnership's income. But partnerships also bear a tax resemblance to S corporations and limited liability companies in that all three are 'pass-through' entities, which means that the business owners – not the business entity – pay taxes on the business income.

In the eyes of the IRS, a partnership exists as long as the costs and profits (or losses) of a venture are split. The partnership provisions of the tax code apply even when two people go into business without a formal partnership agreement (although a formal agreement is always recommended). However, spouses who operate an unincorporated business together can usually report themselves as co-sole proprietors instead of partners. As long as a joint individual tax return is filed, their income tax liability is the same either way; a partnership provides no tax benefits for married couples. And since a partnership requires extra paperwork and tax filings, most spouses opt to report as co-sole proprietors on Schedule C of their tax return. (If spouses file separate tax returns, however, it's possible that they should report as a partnership.)

A partnership must obtain its own federal tax ID number and, even though it pays no federal income tax, must record its income and expenses and file an annual partnership tax return on IRS Form 1065, U.S. Return of Partnership Income. Additionally, individual states may require separate tax reporting and ID numbers, along with an annual state partnership tax return. The state may also charge the partnership an annual fee for operating within its borders.

Partners are technically not employees of their business. They don't receive wages, and the business doesn't pay payroll taxes on their income. Typically, partners take out business profits through periodic 'draws' or 'distributions'. At the end of each tax year, each partner's share of business profits (or losses) is computed and reported on IRS Schedule K-l. All active partnerships must issue a K-l to each partner annually, with a copy going to the IRS. This form shows each partner's 'distributive share' of income or loss, credits, deductions and various other tax items. The IRS records this information to keep track of the income of individual partners to ensure that it's reported on the partners' personal tax returns.

Partners must make quarterly estimated income tax payments on their share of the partnership income. The estimated tax payments must also include each partner's self-employment taxes which, as stated previously, cover Social Security and Medicare. All general partners are subject to self-employment tax on their share of the partnership profits. Conversely, limited partners (the investors) are not subject to this tax. If a partnership keeps profits in the business at the end of the tax year, the partners are taxed on that money, even though they never personally received it. However, if the partnership incurs losses and therefore makes no distributions, no estimated taxes are due.

The tax code makes calculating a partner's taxable income or loss somewhat challenging. For instance, the cash that a partner takes out of the business isn't necessarily the same as that partner's taxable income from the business. A partner is taxed on the amount that he or she is considered to have received from the partnership. This is called the partner's distributive share. This share is normally based on the percentage of the partnership that each partner owns – from 1% to 99%. Unless a formal partnership agreement states otherwise, the tax code presumes that all partners have an equal interest in the business. Therefore, if two people are in business together without any written agreement, it's considered to be a 50-50 partnership.

However, unequal distributive shares, called 'special allocations', can be made if there's a written partnership agreement that authorizes it. A special allocation is a tax code term for any distribution of profits or losses that is disproportionate to a partner's ownership percentage. Giving 65% of the organization's profits to one 50-50 partner and 35% to the other is one example of a special allocation. A partnership agreement could also provide different ratios for splitting profits and losses, such as a 60-40 split for profits and a 75-25 split for losses. Partnership agreements can provide special allocations for any number of reasons. For instance, one partner may work in the business full-time and others only part-time, or one partner may have unique skills or generate more income.

Limited partners – those partners who've invested in a general partnership business but are not involved in its daily operations – are also known as 'passive' investors. Tax rules limit passive investors from claiming partnership losses of more than $25,000 per year on their individual income tax returns. If passive investment losses are greater than this limit, the balance can be carried forward to claim on future years' tax returns. The $25,000 limit applies for each tax year. The passive loss rules typically apply if the limited partner invests (but is not otherwise involved) in such ventures as real estate partnerships.

When people form a partnership, they typically contribute a combination of money, assets and services to the endeavor. Each partner's contribution to the partnership is recorded in his or her capital account. This account is a listing of the contributions and withdrawals of each partner, including the annual distributive share of income or losses received from the partnership. The capital account is each partner's financial history, starting at the beginning and continuing throughout the life of the partnership.

A partnership interest is an investment in the business. For tax purposes therefore, the partner must establish and track his or her investment in the partnership for as long as it's in operation or holds any assets. When each partner contributes only cash for their partnership interests, then the value of their investments is quite easy to calculate. Each partner's capital account simply equals the cash that was contributed.

However, if anything other than money – such as real estate, vehicles or copyrights, for example – is transferred to the partnership, more complicated tax rules take effect. The partner's existing tax basis in the transferred property becomes his or her tax basis in the partnership interest. Therefore, as long as the property maintains the same value from the time that it was originally acquired until the date that it was contributed to the partnership, the tax basis is easily understood.

On other occasions one partner may have ample cash, while another possesses the expertise to run the business effectively. This may create a tax problem because 'services' aren't considered to be property when contributed to a partnership. The tax code imposes a tax cost for taking ownership in a partnership in return for a promise to work in the business. The partner becomes liable for income tax in that year on the value of his or her ownership interest; in other words, it's treated as income to the partner.

Becoming a profits-only partner is one method of circumventing this problem. This clause in the partnership agreement can reward someone who wants to work but doesn't have the money to make a financial contribution to the partnership. Simply put, it states that the individual contributing services has no ownership, but will receive a share of the partnership profits (if any) in exchange for his or her services. Later, the individual can buy into the partnership and become a full partner.

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