Partnerships can either be the simplest or one of the most complicated entity types—depending on how each of the partners relates to the business and what role they play. New entrepreneurs may instinctively view them as too complicated, and even if tax professionals are familiar with the benefits, they may not feel well-versed enough to know when to recommend a partnership structure to their clients. Today, we’ll get you started on understanding and communicating the key reasons business owners can benefit from a partnership, especially from a tax perspective.
Just like the more popular S corporation, partnerships are pass-through businesses. This means they are not subject to corporate income tax. Instead, partnerships pass their profits onto the owners, and the owners then pay personal income tax. This setup can come with a number of tax benefits, including what we like to call the three big “easies.” Read on to learn about these three major benefits and how they can help you when recommending a partnership structure to your clients.
First, moving assets into a partnership is easy and generally does not come with tax consequences. This is determined by Internal Revenue Code § 721, which says that “no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.” In plain-speak, the act of contributing an asset to a partnership does not trigger taxes. Assuming the taxpayer is doing so to receive an interest in the partnership, the IRS does not view this as a taxable gain or loss. If your client is looking to contribute real estate or if their business partners are bringing very different assets and different values to the table, this could make a partnership an attractive option.
Compare this with the rules governing S corporations. If your client wanted to transfer assets into an S corporation in which they are a shareholder, you would look to Internal Revenue Code § 351, which allows for a tax-free incorporation transfer. Here’s the potential hitch: The IRS only allows a tax-free contribution of property if certain requirements are met. One requirement is that the property must be transferred to the corporation in exchange for stock in the corporation. No problem there—this is similar to a partnership where property or cash is exchanged for a partnership interest.
The next requirement is that immediately after this exchange of assets for stock in the S corporation the person (or people) who made the transfer must be in control of the company. The rules for what counts as “control” are defined in IRC § 368, which describes the 80% test and the 50% test (outlined in more detail here). Complying with this requirement can get complicated when shareholders are contributing assets with differing values like vehicles, real estate, and other property. In comparison with an S Corporation, a partnership is a much more straightforward path to tax-free contributions.
From a tax perspective, joining a partnership and contributing assets to the business is easy. Exiting the partnership is just as easy. IRC § 731 states that distributions from the partnership to a partner are not considered a “gain” unless that money exceeds the adjusted basis of that partner’s interest in the partnership. Because the distribution is not considered a gain, the transaction is not taxed. So if a partnership isn’t working out, each partner can simply “take their ball and go home,” so to speak.
Again, we can compare this to what would happen in an S corporation. To exit an S corporation, when a shareholder receives that distribution, it is considered a “deemed sale” at fair market value. So whether the shareholder sees a gain or loss is going to depend on what the shares are worth at that time, according to market prices. Unlike with a partnership, the distribution is not a tax-free transaction by default. So a benefit of a partnership is that if your client needs to exit the business for any reason at all, a hefty tax bill will not likely be an obstacle to that.
Creating an exit strategy may be far from your client’s mind at the moment, so you may need to remind them that there are many reasons a partner may need to leave a business, beyond disagreements among partners. Perhaps the business took out an adjustable-rate loan assuming they would refinance, but they failed to do so before interest rates skyrocket. Suddenly, no one can afford to cover the business’ debt and other expenses. No one starts a business thinking this will happen, but obstacles like this come up, and if they do, your client will be thanking you for this easy “out.”
Easy “Allocations”
A major benefit of partnerships is the ability to make special allocations—to decide internally how shares of income, gain, loss, deductions, or credits are distributed among the partners (see IRC § 704). A partnership is the only entity type where you get to customize how the shares are distributed depending on the partner’s needs and not just their percentage interest in the company. As long as the setup is clearly outlined in the partnership agreement, the IRS will honor it.
An S corporation, on the other hand, does not allow shareholders to allocate items of income and loss however they so choose. Instead, this entity type requires owners to have a “per-share per-day” allocation of business income. If the company fails to do so, they can default on their S election, and the IRS can choose to classify and tax the company as another entity type. If the business is then taxed as a C corporation, this means facing the corporate tax rate and even long-term capital gains taxes on distributions taken from the corporation.
This level of flexibility can be extremely appealing to new business owners. With a partnership, the partnership agreement grants power to the taxpayers to determine who is taxed for what within the partnership. Everything from charitable deductions and tax credits to depreciation and passive income and loss can be individually handled and distributed between partners in a way that brings about the most benefits for each person.
Summary
Flexibility and customization of tax benefits are among the top reasons for choosing a partnership as an entity type. If your client foresees wanting to divide the business’ profits and losses in a way that does not correspond to owners’ percentage interests, a partnership is likely the wisest choice.
Of course, each entity type comes with cons, as well. Make sure your clients are aware that they will have to factor in self-employment tax—the total can be high since it is calculated based on the net profits of the business. Also, as mentioned above, failing to fulfill the IRS’ requirements around special allocations and business agreements can result in dramatic tax consequences.
To learn more about the tax-related pros and cons of each entity type and better advise your clients, become a Certified Tax Planner today.
