A partnership formation is not a separate taxable entity from its owners; the Internal Revenue Service labels a Partnership as a “pass-through entity.” This categorization implies that the partnership itself is not susceptible to the income tax obligation for any profit earned. The business income of the partnership “passes through” the business to the individual partners, who in turn, are required to report their share of profits or losses on their individual income tax returns. Moreover, each partner is required to make a quarterly estimated tax payment to the Internal Revenue Service per year. Partners aligned with the formation are not employees.
Because of this classification, they are not to be issued a W-2 form. Although the partnership, as a formation, does not pay taxes, it is required to file IRS Form 1065 (an information tax form) each year. This information form arranges each partner’s share of the formation’s profits or losses. The Internal Revenue Service reviews this information to ensure that the partners are reporting their income accurately. In addition to Form 1065, the partnership must also file Schedule K-1 to the Internal Revenue Service and to each partner. In turn, each individual partner is required to report the profit and loss information on their individual tax return (Form 1040) with the Schedule E attached.
Because a partnership does not have a department to compute and withhold income taxes, each individual partner must set aside enough cash to pay taxes on their share of the formation’s annual profits. A partner must estimate their tax obligation they will owe for the year and provide payment to the IRS each quarter.
The Internal Revenue Service will require each partner to pay incomes taxes on their distributive share. The distributive share refers to the individual’s portion of profits to which the individual partner is entitled to under the partnership agreement or state law (only if the partnership does not form an agreement). The IRS will treat each partner as though they received their distributive share each year. This ruling means that the partner must pay taxes on their share of the formation’s profits (sales minus expenses) regardless of how much money they actually earn or take from the entity.
Individuals in a partnership—in addition to personal income taxes—are required to pay a “self-employment tax” for all of the profits allocated to the individual from the partnership. The self-employment tax will consist of contributions to Medicare and Social Security programs.
Partners maintain different tax obligations than regular employees of a corporation or other business formation. Because an employer does not withhold taxes from partners paychecks, the partner must pay them with their regular income taxes. Furthermore, a partner must pay twice as much as employees, because the employees’ contributions are matched by their employer. That being said, a partner can deduct of their self-employment contribution from their income, which in turn, lower their tax obligation. Enjoy your day.