Q: Tax Playa, a business associate and I want to go in on a consulting business. How the heck do we report income and expenses? Do we need to have a corporation?
Jonathan, Washington DC
A: No, you do not need to have a corporation. Whenever two tax entities (individuals, corporations, etc.) decide to go into business together, the default under the law is the formation of a partnership. This has lots of ins and outs, so let's dive right in and get our hands dirty...
For more information on this topic, please see IRS Publication 541, Partnerships.
Getting the Terminology Straight
There are three major types of business entities: a corporation, which is totally distinct and pays its own taxes; an S-corporation, which is totally distinct and pays the taxes at the owner level; and the partnership or sole proprietorship (depending on number of parties involved) which is not distinct in the same way and pays taxes at the owner level. For a much more detailed discussion of this, see my article on business entities.
A partnership is an unincorporated business arrangement involving more than one party. Going in on rental properties together (which is common) is not a partnership unless services are performed.
A limited liability company is a tax-disregarded entity. As such, when an LLC has two or more members, it is taxed like a partnership unless it has specifically elected to be treated as a corporation or an S-corporation.
There are two types of partnerships, general and limited:
- General partnerships feature two or more individuals who actively conduct a trade or business. 100% of profits are considered self-employment income, and they are subject to the self-employment tax (the same as a sole proprietor).
- Limited partnerships feature two or more entities who contribute capital but do not actively participate in the trade or business. In other words, they are merely investors. They need only pay income tax on their share of profits.
Members of a family can only be a partnership:
- If capital is a material income-producing factor, they acquired their capital investment in a bona fide transaction, actually own the partnership interest, and actually control the partnership interest;
- If capital is not a material income-producing factor, they joined together in good faith to conduct a business.
Partners generally operate under a partnership agreement (written or oral). It is a very necessary step for partners to lay out their understanding prior to proceeding with partnership activities.
A partnership is terminated when either operations are discontinued or 50% of the interest in a partnership is sold or exchanged.
An investing partnership can elect to be excluded as partners if:
- They own the property as co-owners
- They retain the right to separately dispose of their share of the property
- They do not actively conduct business or delegate someone to do so
Filing Partnership Returns and Reporting Partnership Income
A partnership must file a Form 1065 to show the income and expenses of the partnership. This 1065 then produces Form 1065 K-1s for each partner which shows his share of income and expenses. These in turn flow through to his own tax return.
Besides the current year income or loss, the 1065 keeps track of each partner's basis in the partnership. A basis in a partnership is considered a capital asset. When sold, a capital gain or loss is usually triggered.
Basis in a partnership is increased by contributions of property or money, assumption of partnership liabilities, and share of partnership profits. Basis in a partnership is decreased by draws taken from partnership assets, the partnership assuming liabilities of the partner, and share of partnership losses.
It's important to note that losses on sales between a partnership and a more-than-50% partner are not deductible--rather, they are credited against gain later. Gains are treated as ordinary (not capital) income if more than 50% of the property is owned by a partner, and the property is not a capital (financial services) asset.
A partner can conduct business with his partnership without affecting his basis. For instance, a partner may bill a partnership for consulting. In addition, a partner may be entitled to guaranteed payments above and beyond their share of profits, which also do not affect basis.
Partnerships are subject to the "at-risk" rules. This means that a current-year partnership loss can only be realized by the partner if their basis is not taken below zero. If it is taken below zero, a loss can still be realized if the partner has borrowed funds to cover the loss. If it is still taken below zero even after this, it is subject to the passive activity limit rules. Any loss disallowed by at-risk rules rolls over to a future year to cancel out partnership profits.
There are a few interesting ways that partnership returns treat items when the K-1s are applied to the individual return:
- Partnership income, including income subject to self-employment tax, is reported on the Schedule E, not the Schedule C. A Schedule SE is also prepared, of course.
- Any depreciation is implicit in the distributive share of profit. However, 179 expensing of property is separately reported on the K-1. It must be reported on the individual return, and is subject to the overall limit on 179 expensing in this context.
- Partners may not deduct health insurance premiums or HSA contributions on the partnership level. Rather, this must be done as an adjustment to income on page 1 of the 1040 (the same as a sole proprietor).
- Partners may not deduct contributions to SEP-IRAs, SIMPLEs, or 401(k) plans on the partnership level. Rather, this must be done as an adjustment to income on page 1 of the 1040 (the same as a sole proprietor).
- Husband and wife teams are partnerships, not one single sole proprietor.
- Partnership expenses may be deducted on the Schedule E if they were paid by the partner.