Thanks to Ike Devji for bringing this to my attention: the head of the IRS’s small business unit has stated the service will be changing direction to focus more on small partnerships rather than small businesses. In light of this development, I’m going to spend some time looking at the basics of partnership law taxation.
First, let’s look at some general points regarding partnerships. According to the Uniform Partnership Act, a partnership is “an association of two or more persons to carry on as co-owners a business for profit.” (section 101(6) of the UPA). A partnership can be formal or informal – that is, two or more people can draw up papers to formally state they are in a partnership, or their actions can create a partnership. Partnerships can lead to questions of agency law, wherein lawyers have to figure out if a person who is a “partner” has the “authority” to act for the partnership in a certain situation such as binding the partnership to a contract (this discussion is beyond the scope of the these blog posts). Perhaps most importantly, partners can be “jointly and severely liable” for all partnership debts in their individual capacity (section 306(a) of the UPA).
There are also several different types of partnerships. A general partnership is one where all partners can be held jointly and severely liable for partnership debts and obligations (see Texas Revised Partnership Act, Section 6132b-3.04). In contrast is a limited liability partnership, which is divided between general partners and limited partners. General partners have the same personal exposures, but limited partners are not personally liable for the debts and obligations of the partnership (unless they are also general partners; see Texas Revised Limited Partnership Act, Section 3.03). Their situation is much like a stock holder; they are only liable for the capital they originally contribute to the partnership. There are also limited liability limited partnerships where the general partner is not personally liable for debts and obligations. Finally we have limited liability corporations, which are corporations taxed as partnerships.
So – why would someone elect to form a partnership over a corporation? There are several reasons, the first of which relates to compliance issues. A corporation’s internal governmental structure is strictly outlined in statute. Shareholders meetings must be held according to certain rules and regulations. In contrast, partnership governance is governed by contract; the parties can write a partnership agreement which outlines their respective rights and duties, thereby providing far more flexibility.
But the most important reason for forming a partnership is related to taxation. First, there is no entity level tax on the partnership. Section 701 of the tax code states: “A partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.” Secondly, partnership allocations can be disproportional to partnership interests so long as the allocations have “substantial economic effect.” For example, suppose we have two partners who each contribute 50% of the assets to a new partnership. Under general partnership tax principles, each partner would receive 50% of the “income, gain, loss deduction or credit” of the partnership (Section 704). However, it’s possible to alter this arrangement. For example, partner one could receive all the income while the second partnership would receive all the deductions. We’ll get into this in more detail a few posts down the line.
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