For the last installment in our series on the tax treatment of entity types we’re going to cover the Partnership. If you’ve been keeping up with our posts, this will seem eerily familiar. Why? Because the LLC is typically treated just like a Partnership!
The four considerations we’ve been covering are:
- Pass through of gains
- Pass through of losses
- Transfer of assets to the entity, and
- Transfer of assets from the entity
Today we will cover the Partnership. Before we get into the four considerations, it is important to discuss the legal treatment of a Partnership. A Partnership is simply an agreement between two or more people who share an interest in the same business. From a legal standpoint, courts will rely on any agreement, formal or not. Two people merely splitting costs and sharing profits in a venture is enough. Typically, this isn’t an issue, until it is. Additionally, a Partnership does not provide any liability protection. For more information on limiting liability, see here.
As for the tax considerations;
1. Pass through of gains
The default treatment of a Partnership passes gains through to a shareholder’s personal income statement. With a Partnership, there is no entity- only partners. All profits and losses of the Partnership are passed directly to the partners. This can mean that even when no profits are paid out to the partners, the partners are still personally liable for their share of the taxes on those profits (this is true of the LLC as well). A member of an LLC or a Partnership can contract with the other members as to how the gains are allocated and distributed to the shareholders.
2. Pass through of losses
Again, the default treatment of a Partnership is to pass through any losses to a shareholder’s personal income statement. Losses can be allocated according to the terms of the Partnership.
3. Transfer of assets to the entity
The transfer of assets to a Partnership is not a taxable event, regardless of the amount of control owned by the partner transferring the assets. This could potentially make starting your new company less expensive than with other entity types, especially when there are multiple shareholders. While a Partnership is easy to form, and can easily be given assets, it does not protect the partners from limited liability.
4. Transfer of assets from the entity to partners
When a Partnership decides to transfer assets to a partner, this event is not usually taxable. Either upon distribution or liquidation a partner is responsible for the taxes, if any have even arisen.
Overall, a Partnership is a tax efficient way to get your company started, but lacks the limited liability of other entity choices. In most cases there will not be a tax on transferring assets to and from the company. There is also no double taxation of profits, thus saving the shareholders money. Additionally, if there is a loss, a partner may benefit from a tax reduction.
A Partnership is an easy way to setup a business and has beneficial tax treatment, but does not have the benefit of limited liability. If you’re considering a Partnership, also consider an LLC. They have very similar tax treatment, and only a few formal requirements to set up! Learn more here.