The Benefits of Partnership Taxation

*Photo by Tax Credits is licensed under CC 2.0. *

In a previous post, I discussed the tax disadvantages of operating as a corporation, particularly with regard to the double taxation of corporate profits at both the corporate and personal levels. In this post, I will discuss the benefits of an alternative taxation structure: partnership taxation.

Partnership Taxation v. Corporate Taxation

There are two major tax categories for businesses operating for profit, regardless of the nature of the formation—that is, regardless of whether it is formed as a corporation, LLC, etc. Taxation of such business entities are divided into taxation rules for entities with a single owner and entities with multiple owners. Each of these divisions are further divided into two other divisions.

The taxation of single owner businesses is divided between:

1. Taxation of a sole proprietorship
2. Taxation of a single owner corporation

The taxation of multiple owner businesses is divided between:

1. Partnership Taxation
2. Corporate Taxation

Determining the Appropriate Taxation Model

In the past, determining which taxation rules should apply to a business with multiple owners was extremely difficult and convoluted. To make this determination, the IRS used the corporate resemblance test.

The Corporate Resemblance Test

The corporate resemblance test was the long-standing approach of the IRS in which the agency tried to determine whether the business looked more like a traditional general partnership or a traditional corporation. A business would be classified as a corporation for tax purposes—even if the business was not really a corporation—if it had more corporate characteristics than partnership characteristics.

Four such corporate characteristics the IRS tried to find were the presence of:

1. Limited liability
2. Centralized management
3. Free transferability of interest
4. Continuity of the life of the business

While corporations were obviously taxed as corporations, determining the tax structure of other types of businesses became too burdensome and convoluted. Consequently, the IRS abandoned the corporate resemblance test in favor of check the box rules.

Check the Box Rules

Under the check the box rules, if the business incorporates under state law, it is a tax corporation. (The number of owners is irrelevant.) Also, if it’s publicly traded, it’s—almost always—a tax corporation. Otherwise, it is a general partnership, unless the business specifies otherwise. That is, non-incorporated businesses have the option of being taxed as a general partnership or a corporation. They can “check the box” in selecting the taxation structure they desire.

Determining Partnership Income

Unlike a corporation, which must file its own tax return, every partnership must only file an annual informational return with the IRS. This return must calculate its total income, deductions, and other pertinent tax information and list all tax partners and their allocated share of the business’s profits (or losses). State law determines what each partner’s allocated share is.

This return is just informational, as the partnership itself is not responsible for paying any federal income taxes. Unlike corporations, partnership income is not taxed at the partnership level, instead being passed through to the partners who are responsible for paying the tax due on their share of the income. Profits, therefore, are only taxed once. Partnership taxation can therefore be quite advantageous for small business.

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See Also:

Partnership Tax Terms

The Benefits of Partnership Taxation