Summary: Partnerships require an understanding of the key structures, whether GPs, LPs, LLPs, or LLCs, each come with unique management, liability, and tax implications. Proper structuring, agreements, and knowledge of the necessary tax forms is crucial for compliance and success.

When you enter a partnership, it’s more than a handshake or a signature on an agreement. It’s a meaningful commitment that carries significant tax baggage. The path from entrepreneur to active partner is shaped by several crucial choices that will influence your tax obligations from day one.

Partnerships have been around for decades, and yet, the finer points of what it truly means to be a partner are among the most misunderstood aspects in business. To successfully navigate the world of partnerships, it’s essential to understand the foundational concepts: taxation and structuring.

Exploring the Four Types of Partnerships

The legal structure you select will shape everything from liability and taxation to daily operations. It’s important for business owners to understand the various partnership structures, the foundational concepts, and what sets each one part.

General Partnerships (GP)

The easiest business partnership to form is a GP. The popularity of a GP stems from their ease of creation and no state filing requirements. In a GP, a minimum of two individuals enter a partnership with an equal share of the responsibilities and liabilities for all profits and losses. While GPs do not require filing paperwork with the state, a formally drafted partnership agreement is highly recommended to prevent disputes.

Limited Partnerships (LP)

LPs introduce a more complex structure with two levels of partners — at least one general partner and one or more limited partners. The general partner manages the business, daily operations, and carries full liability, while the limited partners (often considered silent partners) contribute capital but do not participate in daily operations and their liability is limited to the amount invested. Unlike GPs, forming an LP requires filing a certificate of limited partnership with the Secretary of State’s office as well as publicly disclosing their LP stats, and may require the filing of a beneficial ownership information (BOI) report with FinCEN.

Limited Liability Partnerships (LLP)

LLPs are commonly popular among professional services groups, such as law firms and medical practices, who typically require a state license to operate. Every partner in an LLP can participate in management and have limited liability, protecting their personal assets from the partnership’s debts and obligations. While establishing an LLP involves filing with the Secretary of State, the rules vary by state and some limit LLPs to specific industries requiring professional licenses. In addition, the formation of an LLP may require the filing of a BOI report.

Limited Liability Companies (LLC):

An LLC with two or more members offers enhanced flexibility to elect the partnership tax treatment, blending liability protection with pass-through taxation. By default, the IRS taxes multi-member LLCs as partnerships. This structure is often appealing for new businesses that want the best of both worlds: liability protections on personal assets and the simplicity of partnership taxation. Many early-stage businesses begin as LLCs taxed as partnerships for this reason as well as the potential to flow losses through to the founders. However, LLCs may be taxed as a C or S corporation by election.

Who Can Be a Partner and What Are the Types?

Partnerships welcome a diverse range of participates from individuals and corporations to trusts and even other partnerships. Although anyone can become a partner, the key is that everyone agrees to the partnership terms. While partners tend to be individuals, it’s not unusual for entities to hold partnership interest, especially when it involves investment funds or joint ventures.

But who can be a partner? The concept of a “partner” extends far beyond two individuals. Modern partnerships are designed to be flexible with a mix of participants contributing their unique perspectives, advantages, and resources, which may be foreign or domestic.

• Individuals: Often serving as founders or active managers with a personal stake in the outcomes. Their leadership drives the vision and daily operations. In some cases, employees can become partners and may be awarded profit interests.
• Corporations: Companies may participate as partners, especially in joint ventures and investment funds. Corporate partners bring organizational expertise and pooled resources to help navigate complex markets, scale operations rapidly, and discover new opportunities.
• Trusts: Commonly included for estate and asset protection planning or investment purposes, trusts offer unique advantages, such as adding flexibility and protection for beneficiaries.
• Other Partnerships: In some cases, partnerships themselves can act as partners within a larger structure. This layered structured approach enables collaboration across industries to achieve ambitious goals that might be out of reach.

Types of Partners

• General Partners – The driving force behind a partnership as they play an active role in the management of the business and bear personal liability. They shape strategy, make key decisions, and navigate challenges.
• Limited Partners – Silent investors contributing capital to fuel the partnership’s growth, but liability is limited to their investment. Their involvement is strategic, attracting investors seeking opportunity and benefiting from the partnership’s success. They may attend quarterly meetings similar to shareholders in a corporation, but do not participant in daily operations.
• Equity Partners – Common in law and accounting firms, equity partners hold ownership a share of the profits but may or may not be involved in daily operations. While some equity partners immerse themselves in leadership, others contribute knowledge and resources.
• Salaried Partners – A hybrid partner that receives compensation, similar to an employee, but does not generally hold ownership or full legal responsibility of a partner. Salaried partners are ideal for organizations looking to reward talent without extending equity, creating career advancement and retention.

Navigating Partnership Income and Pass-Through Taxation

Understanding partnership taxation starts with the core pass-through principle. Unlike C corporations but similar to S corporations, partnerships do not pay federal income tax. Instead, all income, deductions, credits, and losses are passed directly to the partners, who then report their shares on their individual or business tax returns whether or not they actually receive cash distributions.
While the pass-through taxation model offers partnerships flexibility and transparency, it’s not without challenges. Partners must be cautious when tracking the financial performance of the partnership as well as determining how profits and losses are accurately allocated and taxed. Although partners may be able to offset partnership losses against other income, they must remain aware of the timing and mechanics of reporting, as well as the potential for complex allocations and multi-state tax issues , per the partnership operating agreement.

Key IRS Forms and Deadlines: 1065, Schedule K-1, and 1040

• Form 1065: The Partnership’s Annual Financial Report – Each year, partnerships must file IRS Form 1065 to report the business’s total income, deductions, and other items. This form provides a comprehensive account of the partnership’s financials from the year. The original filing deadline for Form 1065 is March 15 for partnerships that operate on a calendar-year basis. However, the extended deadline is September 15.
• Schedule K-1: Each Partner’s Share – The partnership must also issue a Schedule K-1 to each partner. The K-1 outlines the partner’s share of income, deductions, credits, and other pertinent tax information needed to report on their own tax returns. Even if no money is exchanged, the amount on the K-1 is what partners will use for their own taxes. Schedule K-1s must be completed by March 15, unless the deadline is extended to September 15.
• Form 1040: The Partner’s Tax Return – As a partner, you will use your Schedule K-1 to complete Form 1040, your individual or business tax return. The information for Form 1040 is directly from the K-1, which helps to ensure transparency and compliance. While the extended deadline for Form 1040 is October 15, tax liabilities related to the K-1 income are due by April 15 and may require estimated tax payments during the year for the current year.

Tax Considerations for Partnerships

Partnership taxation is built around transparency and direct reporting. Despite partnerships not paying income tax, partners are taxed on their own share of the business’s results, as outlined in the IRS filings and through the Schedule K-1. Understanding the roles of these forms and taxation responsibilities of each partner, will help to ensure compliance is met during tax season. While GPs, LPs, and LLPs all share the same fundamental taxation structure, none pay tax at the partnership level and there are some unique tax considerations that should be noted.

• GP Taxation and Liability: In a GP, the income is passed through directly to the owners, who are then responsible to report their share of profits and losses on their individual tax return, which are typically subject to self-employment tax. However, since GPs do not benefit from liability protection, they have unlimited personal liability for all business debts and obligations.
• Limited Partnership Taxation: An LPs profits and losses are allocated to limited partners according to the terms of the partnership agreement, however if the economics of the deal are not reflected properly, the IRS may reallocate income or loss. It’s important to note that LPs are generally not subject to self-employment tax on their share of the partnership’s net earnings. The responsibility of paying employment tax falls to the general partner of the limited partnership, who typically receives a management fee that is deducted from the partnership income prior to remaining profits being distributed to limited partners.

Final Thoughts

Partnerships are a unique blend of flexibility and responsibility, from tax compliance to contractual obligations. A partnership demands more than just participation, it requires the right foundation, professional guidance, and proactive organization. While partnerships offer business owners an opportunity to structure deals creatively and reward contributions fairly, understanding the realities of partnership structure and taxation is essential for success.

By recognizing both the challenges and rewards, business owners can maintain their partnership as a compliant legal structure and is set on a path towards sustainable value.