Introduction: Understand the evolving landscape of U.S. Taxation for Partnership Firms in 2024, exploring the Uniform Partnership Act, types of partnerships, and the latest updates from the IRS.
We are aware that under US Taxation, the entity called “Partnership firm” remains the most preferred among tax paying people and undergoes periodical changes in its forms, schedules, instructions etc. Let us learn the updated information from I.R.S., the income tax wing of the treasury department of the American government, considered as the most powerful income tax body among the nations for the past nearly 200 years.
What is a partnership firm?
In United States of America, all the States met at St. Antonio, Texas and finalized Uniform Partnership Act, 1997 and all the States accepted it. The whole discussion of the following article only pertaining to U.S.A. and based on above act as well IRS guidelines on Form 1065, U S Return of Partnership Income which is applicable for tax purposes and have been quoted or used to explain the concept.
An unincorporated organization with two or more members is a partnership by default for federal tax purposes if its members carry on a business, trade or financial operation and obviously share the profits. But then the question that lingers on your mind is whether various types of partnership exist and if so, what are they?
Types of partnership firms
General partnership: A general partnership consist of only general partner. A general partner is a partner who is personally responsible for partnership debts.
Limited partnership: A limited partnership is formed under a state limited partnership law and consists of one general partner and one or more limited partners.
Limited Liability Companies (LLCs)
This is formed under a State Law (like Kansas (Statues) 2016, Chapter 56a (Kansas Uniform Partnership Act). It can be called a partnership unless it has two members for federal tax purposes. It can however, file form 8832, Entity Classification Election, to elect to be taxed as a corporation. Corporation as an entity is likely to be covered in another detailed article later on.
Limited Liability Partnership (LLP)
An LLP is formed under a state law. The purpose of an LLP is to give protection for professionals like doctors, CPAs, and others who wish to operate as partnership. Under the state law, one member gets protection from the negligence or malpractice of another member. Many of these LLPs usually take liability insurance, a concept newly introduced in India too. Unless an LLP files to be formed as a corporation by filing form 8832, it will be taxed as a partnership firm.
Electing large partnership
It is essential that a regular partnership reports certain items to partners separately which gets proper treatment at the tax form of the partner. However, by electing “large partnership” the partnership can combine most of the items at the partnership level and net amounts are passed on to partners. In any case, individual partners have to file their tax returns compulsorily.
By filing Form 1065-B, U.S. Return of Income for Electing Large Partnerships, a partnership opts for large partnership provided it has 100 or more partners in the preceding year which makes the election in its first year, an impossible event.
Limited Partnership
Anti-abuse Rule
If purpose of forming with the principal purpose of reducing the federal tax liability without any no business purpose, the partnership may be disregarded and the tax benefits may be denied.
Family partnerships
To avoid misuse of family partnerships, certain conditions as mentioned below have been imposed:
If the capital is a material income-producing factor (say for inventory), the family member must have got the capital interest in a bona fide transaction which could have been by the way of gift or purchase from the other family member.
In case of a service- oriented industry, the agreement for genuine intention to conduct the business by contributing capital and service to earn profits for sharing among themselves. The purpose can easily be solved by paying wages for their services and pay roll taxes may be avoided by keeping all the partners as parents. Partnership interest may be gifted in due course for working-age children.
The following information may be interesting for any practicing Accountant to know that in case of partnerships where active business is not conducted, the partners may agree to be charged tax liabilities at their own levels though the partner’s distributive share of partnership loss is based on the adjusted basis of the partner in the partnership deed.
However, they need to choose a business tax year for the partnership deed.
The following information has been taken from Internal Revenue Service Publication No. 541 which throws light on joint ventures by husband and wife though the venture may not be treated as partnership.
“Business owned and operated by spouses. If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the business on Form 1065. They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor. However, the spouses can elect not to treat the joint venture as a partnership by making a Qualified To the question which naturally arises about “qualified joint venture election”,
The following para from the same publication contains the answer.
Qualified Joint Venture Election.
A “qualified joint venture,” whose only members are spouses filing a joint return, can elect not to be treated as a partnership for federal tax purposes. A qualified joint venture conducts a trade or business where: the only members of the joint venture are spouses filing jointly; both spouses elect not to be treated as a partnership; both spouses materially participate in the trade or business (see Passive Activity Limitations in the Instructions for Form 1065 for a definition of material participation); and the business is co-owned by both spouses and is not held in the name of a state law entity such as a partnership or LLC.”
The spouses would, however, claim his/her share of income, gain, loss, credit or deduction under Schedule C of form 1040.
General and Limited Partner
In the world over, Partnerships are popular since it is easier to form, customary to follow and dream of achieving the easiest way to do business.
Unfortunately, most of the hastened-up Partnership firms collapse and result in agony for the sincerest partner of the firm.
How to form a good partnership firm?
A general partner is the one who is responsible for the debts of the firm. He is subject to SE (Self Employment) Tax on guaranteed payments and on the distributive share of partnership firm.
Limited partner is liable for the amount of money or property he contributed, or is required to contribute. He is subject to SE (Self Employment) Tax on guaranteed payments and not on the distributive share of partnership income
Fundamentals of Partnership Taxation in U.S.A.
The writer has deliberately used the term U.S.A. so as to deduce the writer to confine the discussion to the position in U.S.A. only. A partnership does not pay income tax at the entry level. Partners’ tax returns carry their share of income, losses, credit or deduction in the partnership firm and thus, partnership firm is just a flow through entity only. The deducted logic is simple that such items appear in their individual tax returns as if they do in their Schedule C of form 1040.
Let us assume any one in a partnership firm forms one with his spouse and start doing business. His distributive share of profit from his firm is $6.5 million (an assumption) while his spouse would get $3.5 million. Every one of them would report their share in form 1040 and the amounts are subject to SE tax.
What is a SE Tax, a word often used in discussion by the writer?
Self-employment tax rate
The law sets the self-employment tax rate as a percentage of your net earnings from self-employment. This rate consists of 12.4% for Social Security and 2.9% for Medicare taxes.
Additional Medicare tax
Additional Medicare tax applies to self-employment income above a threshold. The threshold amounts are $250,000 for a married individual filing a joint return, $125,000 for a married individual filing a separate return, and $200,000 for all others.
One figures self-employment tax (SE tax) himself/herself using Schedule SE (Form 1040). Social Security and Medicare taxes of most wage earners are figured by their employers. Also, one can deduct the employer equivalent portion of SE tax in figuring his/her adjusted gross income. Wage earners cannot deduct Social Security and Medicare taxes.
The self-employment tax rate for self-employment income earned in calendar year 2023 is 15.3% (12.4% for Social Security and 2.9% for Medicare).).
This means that in 2023, Maximum earnings subject to SE tax is as under.
Only the first $160,200 of your combined wages, tips, and net earnings in 2023 is subject to any combination of the 12.4% social security part of SE tax, social security tax, or the Tier 1 part of railroad retirement tax. All your combined wages, tips, and net earnings in 2023 are subject to any combination of the 2.9% Medicare part of SE tax, Medicare tax, or Medicare part of railroad retirement tax.
Partnership Agreement
Any agreement naturally includes the original agreement and further modification, if any. The modifications need verbal or otherwise agreement among the partners. The agreement may be modified in such a way so as not to affect the tax year. Any silence on the part of the agreement attracts the local laws applicable in the state.
Partnership Tax-year
A partnership firm conforms its tax year in consonance with the tax year of its partners. Naturally, a calendar year that helps the individuals as partners is an ideal choice for the partnership firm. If one needs any other form of tax year, his CPA can help him with expert professional advice.
Filing requirements
Every partnership that engages itself in either trade, business or has gross income is expected to file an information return on Form 1065, U.S. Return of Partnership Income, showing its income, deductions, and other required information.
A partnership firm that does not receive any income, deductions or credits for federal income purposes does not file any tax return (Form 1065) for the tax year.
Entities that are formed as Limited Liability Companies (LLCs) classified as partnership firms do use Tax form 1065.
When To File
Generally, a domestic partnership must file Form 1065 by the 15th day of the 3rd month following the date its tax year ended as shown at the top of Form 1065. For calendar year partnerships, the due date is March 15.
Since a large number of my clients enquire about the last date of filing for partnership firms tax returns, the above information may help. However, for anyone who is a partnership member in India, showing global income, may get two months’ extension for filing of tax returns.
Automatic extensions Form 7004, application for automatic extension of time to file certain business income tax, information, and other returns is used by partnerships to extend the filing deadline for five months. But, if any tax has to be paid, delay in payment of the same may attract penalty, interest etc. by the individual partners since partnership firm is a flow through entity.
Analysis of Form 1065, U.S. Return of Partnership Income
Let us explain form 1065 for easy understanding.
Form 1065 can be referred at the following address.
https://www.irs.gov/pub/irs-pdf/f1065.pdf
It consists of 21 items on the page number 1 starting with gross receipts or sales, and prolonging with items like cost of goods, gross profit, ordinary income/loss from other partnership firms, net farm profit/loss, and followed by deductions such as salaries, guaranteed payments to partners, repairs and maintenance, rent, bad debts, depreciation, retirement plans, etc. It ends with item 21, total deductions.
Item22 indicates “Ordinary business income(loss) and items 23-32 indicate tax and payment.
Page 2, 3, and 4 consist of Schedule B with 31 items.
Page 5 consists of Partners’ distribution share items which consist of 21 items under various heads like income/loss, deductions, credits, foreign transactions, alternative minimum tax (AMT) items, and other information which are broadly called as Schedule K.
Similarly, page 6 consists of analysis of net income (loss), Schedule L, Schedule M1, and Schedule M2. In some other article, we may discuss in detail these schedules and their implications for the tax return of partners in the next chapter and also the concept of business expenses widely used item in business forms.
What is the latest?
From the IRS publication under discussion, let us learn the latest developments for partnership firms.
Currently, partners are required to report international tax information on their tax returns on several tax forms and schedules. Partners generally obtain the information required to be reported from their partnerships, usually through narrative statements attached to K-1s. Those statements are compiled in a variety of formats and may be difficult for partners to translate onto their own returns. The proposed changes intend to ease this burden through a standard format that offers greater clarity to both partnerships and their partners.
The Treasury Department and the IRS have released the draft new Schedule K-2 (Form 1065), Partners’ Distributive Share Items – International and Schedule K-3 (Form 1065), Partner’s – Share of Income, Deductions, Credits, etc. – International, both for tax year 2023 and the draft instructions, to allow partnerships and other stakeholders time to consider the proposed changes and to provide comments that could be taken into account in finalizing the schedules and instructions.
The proposed parts included in new Schedule K-2 (Form 1065) replace portions of existing Form 1065, Schedule K, lines 16(a) through 16(r). The proposed schedule provides for international tax information to be reported in a standardized manner generally corresponding to the tax forms listed above.
The above forms are reproduced below. These are not finalized forms, and hence not duly applicable as on date. One can submit his/her observations to IRS at IRS.gov/Forms Comments
Hence please do not use them. Reproduced for just information only.
https://www.irs.gov/pub/irs-pdf/f8865sk2.pdf
https://www.irs.gov/pub/irs-pdf/f8865sk3.pdf
Conclusion
With the evolution of tax over period, partnerships have continued to play the most important role over time due to their simplicity, mode of usage, and their appeal to tax authorities who consider them as a friend and in opposite terms an evil when used to divert the funds through tax haven.
Filing of form 1065 attracts the audit department of IRS since it is widely used to avoid paying taxes by availing a large number of deductions which in many cases not the correct one. Please use the expert advice of a CPA(USA) for filing of the tax return.
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Disclaimer: The above write up compiled mainly from IRS web site is purely for information purposes and one who needs to file returns or find legal solutions, needs obviously a CPA or a legal counsel duly registered in U.S.A.
(Republished with amendments)
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