Partnerships are a commonly misunderstood business structure. Because they are perceived as complicated—and sometimes they can be—many entrepreneurs shy away from this entity type and miss out on the many benefits they have to offer. What makes partnerships distinctive? Partnerships are pass-through entities, so they are not subject to corporate income tax. Instead, they pass the profits onto the owners who then pay personal income tax based on their tax brackets—a setup that can provide significant tax advantages to these owners.
To help you weigh whether a partnership might be the right fit for your business, today we’ll discuss the three big “easies”—three ways that partnerships can make life simpler and even increase tax savings for you and your business.
Easy “In”
When you launch a new business, you and other partners will likely transfer assets to the business to get things going, whether that’s cash, real estate, vehicles, or other resources. “Easy in” means that transferring things into a partnership doesn’t come with any “tax strings” attached. Tax law (governed by the Internal Revenue Code) says that when a partner contributes property to a partnership, this does not result in a gain or loss—in other words, it’s not a taxable event. This is true as long as the partner is contributing that property in exchange for an interest in the business. This tax-free setup is unique among entity types and makes partnerships especially popular when someone wants to contribute real estate or when partners are bringing assets with very different values into the company.
Compare this with a more popular entity choice: the S corporation. If a shareholder wanted to transfer assets into an S corporation, this transaction is considered tax-free only if certain requirements are met. First, the property must be contributed in exchange for stock in the S corporation. That’s fairly straightforward and not altogether different from contributing property to a partnership in exchange for an interest. Second, after this exchange of assets for stock, the person (or people) who made that transfer must immediately be in control of the S corporation. This can prove more complicated. The transaction must pass certain tests known as the “80% test” and the “50% test” (outlined in more detail here) in order to escape taxation. If you have more than one shareholder contributing assets of different values, this can prove complicated to execute on.
In short, partnerships have fewer hoops to jump through in order to make tax-free contributions to the company.
Easy “Out”
Partnerships are just as easy to leave as they are to join. If partners decide to dissolve the business, this entity type essentially allows each person to “take their ball and go home.” When a partner exits and takes assets with them, these distributions are not considered a gain unless that money exceeds the value of the partner’s interest (determined by the adjusted basis). No gain means no tax!
If we compare this again to an S corporation, the rules are different. When you exit an S corporation and take your assets with you, the distribution you receive is considered a “deemed sale” at fair market value. This means that the shareholder will see either a gain or loss depending on what the shares are worth at that time, and that triggers a tax event. The possibility of an increased tax bill can become an obstacle to exiting the company.
Of course, if you are currently launching or growing a new company, an exit strategy may be the last thing on your mind. Remember that disagreements among partners is not the only reason you may need to leave a business. Consider what might happen if you were to take out an adjustable-rate loan for your business. You might do so with the assumption that you can refinance down the road, but what if interest rates increase before you get there? You and your business partners could find yourselves in a situation where no one can afford to cover the business’ expenses. If you find that you need to leave the business, you may be glad that you structured it to provide that easy “out.”
Easy “Allocations”
A unique feature of partnerships is that partners can decide among themselves how to divide up shares of income, gain, loss, deductions, or credits—also known as special allocations. This is the only entity type that allows this tax benefit. Partners can distribute shares according to their individual tax situation and needs as long as that plan is clearly outlined in the partnership agreement.
This differs from an S corporation, which requires shareholders to divide shares according to their ownership percentages. In an S corporation, shares must be distributed “per share per day.” If your S corporation does not meet this requirement, the IRS has the right to revoke your S election and tax your company as a different entity type, such as a C corporation. This would mean incurring the corporate tax rate and even long-term capital gains taxes on distributions taken from the corporation. Ouch!
If you want the benefit of deciding yourselves who is taxed for what and individually handling charitable deductions, depreciation, passive income and loss, and more, a partnership may be the best fit for your business.
Summary
Partnerships are like the Swiss army knife of the tax world. Because this entity type allows you to divide the business’ profits and losses in a way that does not correspond to owners’ percentage interests, partnerships may be ideal for those who are prioritizing flexibility and customization in how tax benefits and burdens are handled.
Of course, partnerships are not without their disadvantages. Self-employment tax can be high, for instance, since it is due on the net profits of the business itself. Also, if you try to take advantage of the special allocation, agreements, or elections but fail to properly follow the IRS’ rules, you can trigger significant tax consequences.
To dive deeper into the pros and cons of each entity type and develop the best tax strategy for your business, start a conversation with a Certified Tax Planner today.
