Selecting an entity type can be confusing. The following is a brief summary of how income from a partnership may be taxed. Since no two situations are the same, always call a professional for insight into your specific circumstances.
Unlike a corporation, a partnership is not a taxable entity. Rather, each partner is taxed directly on his or her share of partnership profits or losses. This is an advantage over operating as a corporation where profits could be taxed twice, once at the corporate level and again at the owner level when dividends are distributed to shareholders.
A new business often has losses in the early years. By operating as a partnership, you can use your share of the partnership’s losses to offset income from other sources, such as investments and compensation from employment. However, to be able to deduct losses currently, you must satisfy the so-called passive activity loss (PAL) rules. As a general rule, as long as you materially participate in the business conducted by the partnership, you will meet the PAL rules.
For tax years beginning in 2018 through 2025, partners may also be eligible to deduct up to 20 percent of domestic qualified business income from a partnership. However, this deduction is limited for higher income partners and phased out entirely for higher income partners of “service partnerships” (such as law or medical practice, financial services, or performing arts).
A partner is not considered an employee of the partnership. Instead, partners pay self-employment tax on their partnership income. The self-employment tax consists of a 12.4 percent Social Security tax (limited to the Social Security wage base amount for the year), a 2.9 percent Medicare tax, which has no upper limit, plus an additional 0.9 percent Medicare tax for higher income taxpayers. This is not an additional tax, but rather the tax that would normally have been paid if the partner had been an employee of a company.
One legal downside of operating as a partnership is that general partners are exposed to unlimited liability from lawsuits that arise in connection with the business even when they are based on the acts or omissions of a partner. This is to be contrasted with operating a business as a corporation where, as a general rule, only the corporation’s funds are at risk.
Fortunately, you do not have to forgo the tax advantages of operating as a partnership to limit your potential liability. You can operate as an S corporation to minimize your liability exposure and yet be taxed similarly (but not identically) to the way you would be taxed if you operated as a partnership.
Another option is the limited liability company. With this choice, your liability exposure also would be reduced and you would be taxed even more like a partnership than if you operated as an S corporation. Give the professionals at TH&W a call before selecting an entity type for your business. We’re just a phone call away.