Choosing the legal form of a business is one of the most important decisions an owner will make. Options include operating as an LLC, a corporation, a partnership, or a sole proprietorship. Legal, operational, and liability considerations all play a role, but tax treatment should also be a significant factor. It is important to understand that a business’s legal form under state law and its classification for federal tax purposes are separate concepts, and the same legal entity may have options to be taxed in different ways. Owners should consider both how the business’s income will be taxed and whether the chosen structure allows the owners’ economic arrangement to be reflected fairly and effectively.

This article focuses on entities taxed as partnerships for federal income tax purposes, the tax matters owners should consider once partnership treatment applies, and the importance of a written partnership agreement establishing the owners’ rights, responsibilities, economic arrangements, and procedures for governing the business.

Which Businesses Are Taxed as Partnerships?

In general, many domestic businesses with two or more owners are classified as partnerships for tax purposes by default, without an additional federal entity-classification filing. The following types of organizations will default to partnership tax treatment:

1. Multi-member limited liability companies, including professional limited liability companies (LLC or PLLC)[1][2]
2. General partnerships (GP)[3]
3. Limited partnerships (LP)
4. Limited liability partnerships (LLP)
5. Limited liability limited partnerships (LLLP)

Although no federal entity-classification election is generally required to obtain partnership treatment, the tax rules governing partnerships are quite complex once the business begins allocating income, admitting new partners, distributing property, or changing ownership.

How Is Partnership Income Reported and Taxed?

Once it is determined that your business will be treated as a partnership for tax purposes, it is important to understand the mechanics of how partnership income is reported and taxed. A partnership is a “flow-through” entity, which simply means that the partnership itself is not subject to federal income tax, but rather the partners themselves are responsible for reporting and paying tax on their “distributive share” of the income of the partnership on their own federal income tax returns. As a result, partners may experience different tax outcomes even when they receive the same percentage and character of partnership income, depending on their individual tax situations. Because partnerships are flow-through entities, a partner may owe tax on allocated partnership income even if the partnership does not distribute enough cash to the partner to cover the resulting liability. However, the good news is that a later cash distribution attributable to income that has already been taxed generally will not be taxable when received.

Once the partnership’s items of income, deductions, tax credits, etc. are determined and filed with the partnership tax return, each partner receives a Schedule K-1 summarizing their distributive share. Determining that distributive share is where partnership taxation can become more complex, which is one of many reasons that every partnership should have a signed, written agreement governing how the partnership will operate and how its tax items will be allocated. For different types of legal entities, this document may have different names: For LLCs or PLLCs it might be called an operating agreement. For GPs, LPs, or LLPs it might be called a partnership agreement.

Why Does a Partnership Agreement Matter?

From a tax perspective, the partnership agreement should contain language expressing how profits/losses and other specific tax items will be allocated among the owners (It is worth noting that these allocations may not always follow a single fixed ownership percentage), but there are also a number of other items that should be addressed that will determine tax treatment/timing, and/or procedures to be followed when certain events occur, such as:

1. Admission of a new partner
2. Sale or transfer of a partnership interest to existing partners or outside persons
3. Death of a partner
4. Contributions of property to the partnership
5. Distributions of cash or property from the partnership
6. Responsibility for partnership liabilities, including guarantees and other arrangements that may affect how liabilities are allocated for tax purposes
7. Loans to the partnership from its partners
8. The treatment of negative partner capital accounts, including whether a partner is required to restore a deficit by contributing cash
9. Sale of the partnership’s assets
10. Liquidation of the partnership

It should be noted that this list is not exhaustive and does not necessarily address other non-tax items that should be included in a good partnership agreement, but it is meant to provide common examples of things that should be addressed that may impact tax treatment in certain key circumstances.

How Flexible Can Income Allocations Be in the Agreement?

One of the advantages of the partnership taxation regime over the S corporation regime is the ability to be more flexible with allocations of income. That is, partnerships may allocate income, gain, loss, deduction, and credit in ways that do not strictly follow ownership percentages (S corporations must allocate on a pro rata, per-share, per-day basis, subject to limited elections and exceptions). However, any special allocations must comply with complex federal tax rules intended to prevent partnerships from shifting timing or character of income to specific partners for the purpose of tax savings. Generally, an allocation must have “substantial economic effect.”

In simple terms, an allocation has substantial economic effect when the partner receiving the tax benefit or burden also bears the corresponding economic benefit or burden. The allocation must affect what the partners ultimately receive from, or are required to contribute to, the partnership and cannot exist solely to produce a preferred tax result. If the partnership or its partners are examined, the IRS may challenge an allocation that lacks substantial economic effect and does not otherwise reflect the partners’ interests in the partnership. Accordingly, the partnership agreement generally should be drafted to comply with the applicable Treasury Regulations (Regs. Sec. 1.704-1(b)(2)(ii) and 1.704-1(b)(2)(iii)) and should contain provisions supporting the intended allocations. Just as importantly, the partnership must maintain its records, capital accounts, allocations, and distributions consistently with the agreement in practice.

Before signing the partnership agreement, each partner should read and understand its terms, including both the matters it addresses and those it leaves unresolved. Partners should also understand their rights and available options if any of the events listed above arise during the life of the partnership. These provisions should accurately reflect the partners’ understanding of their business arrangement and should be discussed before the agreement is finalized. The partners may wish to have the agreement reviewed by the partnership’s tax adviser to help ensure that its legal and tax provisions work together as intended.

Putting It All Together

While forming a business entity taxed as a partnership may be relatively straightforward, the tax reporting and allocation of income can be considerably more complex. A well-drafted partnership agreement is essential to clearly document the partners’ economic arrangement, and the partnership should operate consistently with those terms. The agreement should also be reviewed periodically—particularly when ownership changes or other significant events occur. Feel free to contact your BCS tax advisor for specific questions as they apply to your situation.

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[1] Note 1 on LLCs: A single-member LLC generally cannot be taxed as a partnership. Unless it elects corporate treatment, it is disregarded as separate from its owner for federal income tax purposes, and its activity is reported directly by the owner.

[2] Note 2 on LLCs: An eligible LLC may elect C corporation treatment by filing Form 8832 or, if it qualifies, S corporation treatment by filing Form 2553.

[3] Note on general partnerships: A general partnership may arise by operation of law, without formal state filings or a written agreement. When two or more persons carry on a business together and share profits, they may be treated as a de facto general partnership for tax purposes.