Partnerships and multi-member LLCs, which are taxed as partnerships, are commonly used for business and investment purposes. Why? A main reason is for tax benefits they offer, especially the advantage of pass-through taxation. However, these entities must adhere to specific, sometimes complex, federal tax rules.
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A partnership operates under a partnership agreement, outlining the roles and responsibilities of both the entity and its partners. Similarly, an LLC follows an operating agreement that defines the rights and obligations of the entity and its members. It's important that these governing documents address tax-related considerations. Consider some essential points when drafting partnership and LLC agreements.
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Taxation Basics for Partnerships
In a partnership, tax-related information is passed through to the individual partners. Each partner receives a Schedule K-1 annually, which details their share of the partnership’s tax items. The partnership itself does not pay federal income tax. Instead, this "pass-through" structure allows partners to report their portion of income, deductions, and losses on their personal tax returns (such as Form 1040 for individual partners).
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Partners can also claim deductions for partnership losses passed through to them, though these are subject to several federal tax limitations, including passive activity loss rules.
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Special Tax Allocations
Partnerships have the flexibility to make special tax allocations, meaning they can distribute tax-related items such as income, deductions, gains, or losses among partners in a way that doesn't match the partners’ ownership percentages. For example, a partner who holds a 50% interest in the partnership could be allocated 80% of the depreciation deductions if they are in a higher tax bracket, while the lower-tax-bracket partner holding the same 50% interest might receive only 20% of those deductions.
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Any such special allocations must be clearly stated in the partnership agreement and comply with IRS regulations to be valid.
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Distributions for Tax Liabilities
Partners are taxed on their share of the partnership’s income and gains, regardless of whether they receive cash distributions. As a result, partnership agreements often include provisions requiring the partnership to distribute enough cash to cover partners’ tax liabilities. These liabilities can vary depending on each partner’s specific tax situation, so the agreement should outline how tax distributions will be calculated.
For instance, for long-term capital gains, a provision may require the partnership to distribute an amount equal to 15% or 20% of each partner’s share of the gains. These distributions are typically made in early April to help partners cover taxes owed on income from the previous year.
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Need Help?
When structuring a partnership or LLC, it's essential to address tax considerations in the agreement. Reach out to us for assistance with your business structure and tax planning needs.