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 from a previous post we indicated that general partners, who are decision makers, are treated differently than limited partners. 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 an investor in a partnership, work less than 500 hours in a given tax year for the partnership, and you do not participate in its management, you are considered limited in your liability and your income is usually considered passive income. Passive income, as you will recall, is not subject to FICA or Medicare. Therefore, your income will be subject to federal and state income taxes based on your marginal tax rate only.
As a limited partner, you will use the K1 issued by the business to populate your Schedule E. Since your income is considered passive income, you are not subject to self-employment taxes.
Throughout the year, the business can make periodic distributions (partner draws) 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. 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 partnership.
The partnership agreement may also provide guaranteed payments to limited partners whether the partnership makes a profit or not. 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. These guaranteed payments are considered earned income to the partner and are subject to self-employment taxes so that the partner can deduct self-employed health insurance and retirement contributions.
In addition to any guaranteed payment made to the partner, the partner’s profit share and their partner draws will also appear on the K1. However, since the partner’s profit share is considered passive income, it is not subject to self-employment taxes.
When it comes to guaranteed payments or 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 the limited partner(s) of your limited partnership properly?
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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