Like the sole proprietor, a partnership is not taxed at the partnership level. Instead, a partnership is considered a pass-through entity, meaning the profit or loss generated from the partnership is passed to each partner via schedule K1 and is taxed on each partner’s own income tax return.
To generate a K1 the partnership must calculate its profit and loss by subtracting the eligible business expenses from total revenue. Next, each partner’s income / loss share is determined by the total profit / loss percentage ideally dictated in the partnership agreement.
For example: Vicki and Michele form an architect LLC with Vicki contributing $30,000 and Michele, $70,000. Profit/loss is divided along the lines of their investment in the business, so the profit-sharing percentage is 30/70 between Vickie and Michele.
Let’s say the business generated $100,000 and paid $90,000 in expenses. The net profit of $10,000 will be passed through to Vicki $3,000 and $7,000 to Michele.
If both are actively running the business together, then both will have to pay Social Security and Medicare taxes calculated on schedule SE – Self-employment Tax. This is to recognize that they are both employer and employee and pick up the expenses accordingly.
At first glance, this may seem complicated, however they are also entitled to take half the SE taxes and deduct them on their returns.
Since partnership returns (form 1065) are information returns with no income taxes due upon filing; no income taxes are required to be withheld. It is the partners’ responsibility to estimate the share of the profit they will receive and estimate and pay the taxes due. As we are a “pay as you go” income tax system, interest will be accrued if estimated taxes are not paid when the income/revenue is earned. The interest will be added on to the taxes owed when partners file their individual income returns.
This might come as a surprise – even if the partners did not take any profit out of the business and decided to leave the cash in the business to pay for anticipated expenses. The tax owed did not take that into consideration; the point being revenue is taxed when earned not when it is withdrawn.
On the other hand, business expenses are usually recognized in the year paid which offset the business revenue. Below are some common expenses:
- Auto Expenses: business usage portion, including mileage, repairs, insurance, etc.
- Depreciation: is money paid for Fixed Assets which are expensed over time depending on the type of assets
- Legal and Professional Fees: fees paid to attorneys, CPAs etc.
- Insurances: professional liability insurance, director’s insurance, etc.
- Travel Expenses
- Interest on business loans, not interest on taxes owed
- Equipment: may be able to elect section 179 and expense them in the same year instead of amortizing the expenses over a period of 3 to 7 years (or longer)
- Education Expenses: if continued education courses or other business improvement classes are required
- Taxes: paid to state and local, not federal
In addition to these common business expenses, setting up a suitable retirement plan will not only decrease the current tax liability, but it will also help save for retirement. Depending on the structure of the business, cash flow and the goals of the business owners, a suitable retirement plan is yours if you act. Friendly reminder: some retirement plans are subject to ERISA regulations and some are required to be set up before the end of the tax year; some require owner’s match to the employee’s contributions while some are contributed from business profits, etc. Please consult with a financial advisor along with your third-party administrator to help custom design an appropriate retirement program to suit your goals.
If you need a consultation or a second opinion, here is the link to access my appointment calendar, https://square.site/book/9AXE057BXPYYG/annie-hung-scanga.
To the best of my knowledge, I wrote this article in general terms as each person’s situation varies. Tax laws do change from time to time. No guarantee is made or claimed through this article. Personalized advice is recommended to consult’s one’s own advisor or contact the author.