Are you considering inviting an employee or an outsider to participate in your existing partnership? Before making any commitments, it’s important for you and the prospective partner to understand the potential federal tax implications.
Important: A limited liability company (LLC) with multiple members (owners) is classified as a partnership for federal income tax purposes — unless you elect to treat the LLC as a corporation. This article assumes that you haven’t made this election. If you have made it, entirely different tax considerations apply.
Address Tax Issues Upfront in Your Partnership Agreement
Since partnerships have multiple owners, multiple tax-related issues can come into play. You need a carefully drafted partnership agreement to handle potential issues even if you don’t expect them to arise. You may want to include:
– A buy-sell agreement to cover partnership interest transfers when a partner exits, as well as how to handle the divorce, bankruptcy or death of a partner,
– A noncompete agreement,How tax allocations will be calculated in compliance with IRS regulations, and
– How distributions will be calculated and when they’ll be paid. For instance, you may want to call for cash distributions to be made in early April of each year to cover partners’ tax liabilities from their shares of partnership income for the previous year.
Depending on your situation, there’s a good chance that you’ll need to amend your partnership agreement to cover eventualities that arise, or could arise, when you bring a new partner on board.
Advantages of Partnership Taxation
The federal income tax rules for partnerships and LLCs treated as partnerships are generally favorable. That’s why many businesses choose to operate as partnerships with multiple partners or as multi-member LLCs instead of as corporations with multiple shareholders.
The same advantages apply to LLCs treated as partnerships for tax purposes. So, when you see the words “partnership” and “partner,” you can substitute “multi-member LLC” and “member.”
Here are six key tax advantages to operating as a partnership:
1. Pass-through taxation. Each partner’s share of partnership taxable income items, gains, deductions, losses and credits are passed through to that partner. Then each partner — including the new incoming partner — reports those tax items on his or her individual income tax return. The partnership itself doesn’t pay federal income tax. So, you don’t have to worry about the double taxation issue that can potentially affect businesses that operate as C corporations.
2. Deductible partnership losses. The partners can deduct partnership losses passed through to them on their individual returns, subject to various limitations. These limitations may include:
- The passive loss rules,
- The at-risk rules,
- The excess business loss disallowance rule, and
- The partnership interest basis limitation rule.
Consult your tax advisor for details about these limitations and others that may apply. There’s a good chance they won’t apply to you or your partners, but double-check with your tax advisor to be certain.
3. Increased basis from partnership debts. Each partner’s tax basis in his or her partnership interest is increased by the partner’s share of partnership liabilities. The additional tax basis from partnership debts allows each partner to deduct partnership pass-through losses in excess of his or her investment in the partnership (subject to the various potential limitations).
The additional tax basis from partnership debts also allows each partner to receive cash distributions in excess of his or her investment in the partnership. Note that limited partners normally don’t receive any basis from partnership recourse debts unless they personally guarantee them. However, limited partners can receive basis from nonrecourse partnership debts. Ask your tax advisor for details on basis-from-debt issues.
4. Tax basis step-up for purchased interests. If your incoming partner purchases a partnership interest from an existing partner, the new partner can step up the tax basis of his or her share of partnership assets. This minimizes taxes for the new partner when the partnership later sells those assets or converts them to cash. This privilege is available if the partnership makes an Internal Revenue Code Section 754 election or already has one in effect.
5. Tax-free asset transfers with the partnership. Partners have flexibility to make federal-income-tax-free transfers of assets (including cash) between the partners and the partnership. In contrast, if you operate your business as an S or C corporation, you have much less flexibility for transfers of assets between shareholders and the corporation. For corporations, transfers of appreciated assets will trigger taxable gains.
6. Special tax allocations. Partnerships can make special (disproportionate) allocations of taxable income, tax losses and other tax items among the partners. For example, an incoming new high-tax-bracket partner with a 20% interest could be allocated 80% of partnership depreciation deductions while lower-tax-bracket existing partners who own 80% of the interests are allocated only 20% of the depreciation deductions. Later on, the high-bracket partner can be allocated more of the partnership’s gains from selling depreciable assets to compensate for the earlier special allocation of depreciation.
Partnership Taxation Disadvantages and Complications
There are a few important tax disadvantages and complications that partnerships should consider. A prospective new partner should understand these concerns before joining the business.
Exposure to SE tax. Your new partner may owe self-employment (SE) tax — consisting of the 12.4% Social Security tax component and the 2.9% Medicare tax component — on some or all the income passed through to him or her by the partnership. (The partner will be able to deduct the “employer” portion of these taxes — 6.2% and 1.45%, respectively — from his or her SE income.) At higher income levels, the new partner may also owe the 0.9% additional Medicare tax.
In contrast, if you run your business as an S or C corporation, the partners will owe the “employee” portion of Social Security and Medicare taxes (6.2% and 1.45%, respectively, in the form of the FICA tax) plus, if applicable, the 0.9% additional Medicare tax only on amounts paid out as salary to them.
Important: Limited partners owe SE tax only on guaranteed payments received for services rendered to the partnership. General partners don’t qualify for this break.
Complicated Section 704(c) tax allocation rules. If the partners, including your incoming partner, simply contribute cash to acquire their partnership interests, then making federal income tax allocations is fairly straightforward. But if a partner contributes assets with fair market values that differ from the assets’ tax basis, Sec. 704(c) allocation rules come into play. Long story short, these rules require the partnership to make tax allocations that factor in the difference between the tax basis and the fair market value of contributed assets.
For example, let’s say your new partner contributes raw land worth $1 million with a tax basis of only $250,000. If the land is later sold by the partnership for more than $250,000, the first $750,000 of taxable gain must be allocated to the new partner under the Sec. 704(c) rules. These rules may also come into play in more complicated ways, such as allocating depreciation deductions for contributed depreciable assets. Ask your tax advisor for more details if partners contribute noncash assets.
Disguised sale rules. The partnership disguised sale rules are one of the most complicated subjects in partnership taxation. These unfavorable rules can cause what appear to be nontaxable transfers of assets between partners and partnerships to be treated as partially or wholly taxable sales.
For example, let’s say your incoming partner contributes appreciated property to the partnership and then receives a cash distribution from the partnership. Under the disguised sale rules, this can potentially be treated as a wholly or partially taxable sale of the appreciated property to the partnership, depending on the size of the distribution and how closely it occurs in time to the property contribution. If disguised sale treatment applies, your new partner could face an unexpected tax liability.
Consult your tax advisor before finalizing significant partner or partnership transactions, including transactions with an incoming partner. Proactive planning can often prevent unexpected and adverse tax outcomes under the disguised sale rules.
For More Information
If you operate your business as a partnership or LLC that’s treated as a partnership for tax purposes, you and the other owners can benefit from the generally favorable partnership federal income tax rules summarized here. But applying these rules can get complicated, and an incoming partner can potentially add to the complications. Consult your tax advisor before inviting a new owner to join your group.