Archives for January 2021

The following is a modified excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

Partnerships themselves are not actually subject to Federal income tax. Instead, they — like sole proprietorships — are pass-through entities. While the partnership itself is not taxed on its income, each of the partners will be taxed upon his or her share of the income from the partnership.

Form 1065

Form 1065 is the form used to calculate a partnership’s profit or loss. On the first page, you list the revenues for the business, list the expenses for the business, and then subtract the total expenses from the total revenues. It’s exactly what you would expect.

On the second and third pages of Form 1065 you answer several yes/no questions about the nature of the partnership. For instance, you’ll be asked whether any of the partners are not U.S. residents, whether the partnership had control of any financial accounts located outside of the U.S., and other questions of a similar nature.

Schedule K and Schedule K-1

The fourth page of Form 1065 is what’s known as Schedule K. Schedule K is used to break down the partnership’s income into different categories. For instance, ordinary business income goes on line 1, rental income goes on line 2, interest income shows up a little bit later on line 5, etc.

After filling out Schedule K, you’ll fill out a separate Schedule K-1 for each partner. On each partner’s Schedule K-1, that partner’s share of each of the different types of income is listed.

EXAMPLE: Aaron and Jake own and operate a partnership. Their partnership agreement states that they’re each entitled to exactly 50% of the partnership’s income. If, on Schedule K, the partnership shows ordinary business income of $50,000 and interest income of $200, each partner’s Schedule K-1 will reflect $25,000 of ordinary business income and $100 of interest income. This income will eventually show up on each partner’s regular income tax return (Form 1040).

What’s important to note here is that allocations from a partnership maintain their classification once they show up on the partners’ individual tax returns. This is important because some types of income are taxed differently than other types of income. For instance, long-term capital gains (gains from the sale of investments that were held for greater than one year) are currently taxed at a maximum rate of 23.8%, and in some cases they are not taxed at all.

EXAMPLE: Aaron and Jake’s partnership buys shares of a stock, holds the shares for several years, and then sells them for a gain of $10,000. When Aaron’s $5,000 share of the gain shows up on his tax return, it still counts as a long-term capital gain (as opposed to counting as ordinary income). It will, therefore, be taxed at a maximum rate of 23.8%, even if Aaron is in a much higher tax bracket.

Similarly, deductions maintain their character when passed through from a partnership. For example, if a partnership makes a cash contribution to a qualified charitable organization, that contribution will maintain its character when it shows up on each of the partners’ personal returns. That is, it will count as an itemized deduction, subject to all the normal limitations for charitable contributions. (For 2021, there is a special rule that even people who claim the standard deduction can claim a deduction — of up to $300 or $600 if married filing jointly — for cash contributions to charity.)

Self-Employment Tax for Partnerships

Ordinary business income from a partnership is generally subject to the self-employment tax when it is passed through to general partners. This makes sense given the rule that we just discussed about income maintaining its classification when allocated to a partner on his or her K-1.

Deduction for Pass-Through Income

Because partnerships, like sole proprietorships, are pass-through businesses, profit from a partnership will also qualify for the deduction for pass-through business income. With a partnership, your deduction is for 20% of your share of the partnership’s profit, subject to limitations.

Allocated Profit vs. Distributed Profit

One thing that surprises the owners of many partnerships when their first tax season rolls around is the fact that partners get taxed on their allocated share of the partnership’s profit, even if nothing was distributed to them.

EXAMPLE: Michelle, Kayla, and Tim start a partnership. Their partnership agreement states that profit or loss will be evenly allocated to the partners.

In the first year, their partnership makes $60,000. However, they’re sure that their business could grow quickly if they had the capital. So, they decide not to distribute any cash to the partners. Instead, they make plans to use all $60,000 to buy new production equipment next year.

Despite the fact that none of the partners actually received any cash payout, they’re each going to be taxed on $20,000 of business income (1/3 of the $60,000 total). That is, each is taxed on his or her “allocated profit” of $20,000 rather than his or her “distributed profit” of $0.

[Note: Profits and losses in a partnership are not required to be split evenly between the partners. The partners can choose to split the profit or loss in any way they choose. It just makes the math in the examples easier if we give each partner an equal share.]

In Summary

• Like sole proprietorships, partnerships are “pass through” entities. A partnership is not subject to federal income tax. Rather, its owners are subject to Federal income tax on their share of the profit.
• Form 1065 is used to calculate a partnership’s profit or loss.
• Schedule K is used to break down a partnership’s income and deductions by category. Schedule K-1 is then used to show each partner’s allocated share of the various types of income and deductions.
• Income and deductions from a partnership maintain their original classification when they are passed through to a partner. For example, long-term capital gains will be taxed at a max rate of 23.8%, and ordinary business income is subject to self-employment tax.
• For tax years 2018-2025, you can claim a deduction equal to 20% of your share of a partnership’s profit, subject to limitations.
• Partners are taxed on their allocated share of the profit, regardless of how much of the profit is actually paid out to them.

The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

As far as federal income taxes are concerned, LLCs don’t really exist. The Internal Revenue Code — the body of law that outlines all federal income taxation — treats each LLC as if it were one of the other types of entities.

Specifically, unless they have elected otherwise, single-member LLCs (LLCs with one owner) will be taxed as sole proprietorships, and multiple-member LLCs will be taxed as partnerships. Because of this tax treatment, LLCs — like sole proprietorships and partnerships — are often referred to as “pass-through” entities.”

EXAMPLE: Kali owns and operates a restaurant as a sole proprietorship. She later decides to form an LLC for her business. The business will continue to be taxed as a sole proprietorship (for federal tax purposes at least).

EXAMPLE: Steve and Beth own and operate a winery. After learning about the potential dangers of unlimited liability in a partnership, they decide to form an LLC. The business will continue to be treated as a partnership for federal income tax purposes.

LLCs Taxed as Corporations

Sometimes, after forming an LLC, the owner(s) of the LLC will decide that they would benefit from being taxed as a C-corporation rather than as a sole proprietorship or partnership. When this happens, the owner(s) have two options:

1. Form a corporation and transfer all of the assets from the LLC to the corporation, or
2. Fill out a form (Form 8832) electing corporate tax treatment.

The second option is certainly the easier and less costly of the two.

The same thing can be done should the LLC’s owner(s) decide that S-corporation taxation would be beneficial. The only difference is that a different form (Form 2553) is used to notify the IRS of the election.

Disregarded Entities

If a single-member LLC does not elect to be taxed as a corporation, it is referred to as a “disregarded entity” because its existence is disregarded entirely as far as federal income tax is concerned. (That is, the LLC and its owner are considered to be one and the same.)

State Taxation of LLCs

Again, unless an election is made otherwise, LLCs will be treated as either sole proprietorships or partnerships for federal tax purposes. However, depending upon where your business is located, state income taxes might not work the same way.

For example, some states tax LLC directly on their income rather than (or in addition to) taxing the owners on their share of the income. For instance, in California, LLCs are subject to an $800 annual tax, as well as an income-based fee if the LLC earned more than $250,000 in California that year.

EXAMPLE: Braden runs a sole proprietorship in California for his part-time video production business. He earns roughly $3,000 per year from the business, and is considering forming an LLC. However, even with an annual income of only $3,000, a California LLC would still be subject to a tax of $800, or more than one-quarter of the business’s total profit. Braden eventually decides that the benefits of forming an LLC would be outweighed by this disproportionately large tax.

Before deciding to form an LLC, it’s definitely a good idea to find out precisely how your state taxes limited liability companies.

In Summary

• For federal tax purposes, single-owner LLCs are treated as sole proprietorships, and multiple-owner LLCs are treated as partnerships.
• An LLC can elect to be taxed as a corporation simply by filing a form with the IRS (Form 8832 for C-corporation tax treatment or Form 2553 for S-corporation tax treatment).
• Some states do not tax LLCs the same way that the federal government does, so be sure to find out how your own state taxes LLCs before creating one.