Look at the Downsides
Left to their own devices, some business owners would choose an entity type that is rumored to have tax advantages, cross their fingers, and hope for the best. Fortunately, with you on their side, taxpayers don’t have to rely on vague advice or blind optimism. Tax planners are worth their weight in gold because they investigate the pros and cons of any potential tax strategy before making a recommendation. This is especially true when it comes to entity selection. Tax planners know well that one choice determines so much of a taxpayer’s destiny.
Is a Partnership Worth the Trade-offs?
You may find that many clients who own a partnership don’t fully understand the tax implications. It all goes back to the purpose of the partnership entity—to provide a simple way for more than one owner to go into business together. Some clients are drawn to partnerships because of their structural flexibility or pass-through entity perks. Others don’t realize they’re classified as a partnership until tax season rolls around.
No matter the details, it’s our job as tax professionals to question the entity choice and, when necessary, to introduce our clients to the downsides of partnerships.
The Disadvantages
The tax traps to watch for when it comes to partnerships mostly fall into four categories: liability, compensation, self-employment tax, and stock.
- General partners are subject to unlimited liability. The partner that has operational control over the business also has responsibility to pay all the business’ debts. This also extends to lawsuits and other financial obligations. If a business owner is nervous about their personal assets being at risk, they will either need to set up additional protection or avoid partnerships altogether.
- Partners cannot be paid as employees or receive tax-free fringe benefits. They are instead required to receive guaranteed payments, which are defined through the partnership agreement. Tax consequences can arise if the business suffers a loss and cannot afford to pay the guaranteed payment. The partnership will be required to make up for it at some point. This can trigger higher taxes and limit qualified business income in future years.
- Guaranteed payments are subject to self-employment tax. This is where you will need to caution some clients against a knee-jerk reaction. Self-employment tax is not necessarily a dealbreaker. Without doing the math, you won’t know whether potential taxes saved through the partnership structure could outweigh this cost.
- Partnerships cannot issue stock. Aside from the limit on financing and growing the company, this also means that the business cannot benefit from deducting stock losses. With a C or S corporation, qualifying small business stock losses can even be deducted as ordinary losses.
Why Compliance Isn’t Enough
Weighing the disadvantages, examining the partnership agreement, calculating the tax bill if the business switched entity types: steps like these mark the difference between a reactive compliance-focused tax professional and a proactive tax planner. Our job is to have the hard conversations, identify other advisors when needed, and bring a higher level of critical thinking to the tax planning process. This is what allows us to charge a higher rate—and what makes our work well worth it for our clients.
Hone Your Expertise
You don’t have to read each of the 77,000 pages of U.S. tax code cases and regulations to be an expert. That’s because the American Institute of Certified Tax Planners has taken the complexities of tax law and broken them down into practical strategies you can bring to your client. Learn how to interpret the tax code while also discussing the most relevant tips and tactics for saving your clients money right here and now.
