A limited partnership is composed of more than one partner. Therefore, as we discussed in a previous post, the business will submit an informational return to the IRS known as a Form 1065. Each of the partners will be issued a K1 that will indicate the portion of the profit and loss that the individual will be responsible for claiming on their Schedule E (supplemental income and loss) and their personal 1040 tax return.
The K1 for each partner will designate how the partner’s share of income, deductions, and credits are allocated for tax purposes.
Remember we indicated that general partners are treated differently than limited partners who are decision makers. Moreover, if you are a partner but work more than 500 hours in a given tax year, you are treated the same as a general partner for tax purposes.
To be clear, while the partners in a limited partnership are responsible for paying the taxes for a profitable business based on their individual marginal tax rates, the partnership does not have to physically write the partners checks for the total amount of the businesses profits. In fact, it is not wise to distribute 100% of the profit to the partners. The business should leave some of the equity in the business as there needs to be sufficient cash to cover any net loss the business may incur in the future and to provide the needed capital for future growth.
For my owners, I would generally issue distributions to cover the owner’s taxes and we would retain the rest of the profits in the business to reinvest in the business’s growth.
When you are a general partner in a limited partnership you by default are like an employee of the company, and therefore, all your income is considered earned income. Moreover, since you are also a partner, all your income will be subject to self-employment tax (15.3%) in addition to your marginal tax rate for federal and state income taxes. Remember that your marginal tax rate is the result of your collective income from all sources and that each owner can potentially have a different marginal tax rate. Finally, since you are a general partner, your liability protection is not as limited as limited partners because you are a decision maker.
While being a general partner causes all your income to be considered earned income, making it subjected to self-employment tax and your liability not being as limited as a limited partner’s, the good news is you are eligible for some deductions such as for healthcare and/or retirement plan contributions.
As a general partner, you will use the K1 issued by the business to populate your Schedule E. Since you are also a general partner and subject to earned income, you will also need to complete a Schedule SE (self-employment tax) to report your income that is subject to self-employment taxes.
Throughout the year, the business may make guaranteed payments as a way of compensating you as the general partner. Guaranteed payments differ from a salary or wages in that the business does not withhold taxes on guaranteed payments. However, the guaranteed payments are an expense to the business that will lower its taxable income. The guaranteed payments made to you as the general partner are subject to self-employment taxes when you file your personal taxes.
The business may also make periodic distributions (partner draw) to compensate you as a partner. The business maintains a capital account for each partner. As a distribution (partner draw) is made, the partner’s equity is reduced. Like a guaranteed payment, the business does not withhold taxes on distributions (partner draws). Since distributions (partner draws) are not an expense to the business, they are not a deduction to the business.
All compensation made to you as the general partner including guaranteed payments and your profit share are subject to self-employment taxes when you file your personal taxes. Your profit share and guaranteed payments will be included on your K1.
When it comes to guaranteed payments and your profit share, the onus is on you to estimate the taxable income you will receive and then make quarterly deposits to the IRS using Form 1040-ES to cover the anticipated annual tax liabilities. The same is true for your estimated state taxes. To avoid IRS penalties, your tax estimates should add up to at least 90% of your estimated tax liability.
Are you paying yourself properly as the general partner in a limited partnership?
I would like to acknowledge Karen Absher of KSA Financial & Tax Services for her gracious assistance as a reviewer to make sure that the tax issues conveyed in this post were an accurate representation of US tax law.
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