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Approximately 543,000 new businesses get started each month, adding to the roughly 19.4 million existing nonemployer businesses. Of the those total businesses, roughly 8% are partnerships. If you are considering forming a partnership to run a business there are some specific legal and tax considerations involved in operating in that fashion.
Unlike a corporation, a partnership is not a taxable entity. Rather, each partner is taxed directly on his or her share of partnership profits or losses. This is an advantage over operating as a corporation where profits could be taxed twice, once at the corporate level and again at the owner level when dividends are distributed to shareholders.
A new business often has losses in the early years. By operating as a partnership, you can use your share of the partnership’s losses to offset income from other sources, such as investments and compensation from employment. However, to be able to deduct losses currently, you must satisfy the so-called passive activity loss (PAL) rules. As a general rule, as long as you materially participate in the business conducted by the partnership, you will meet the PAL rules.
A partner is not considered an employee of the partnership. Instead, partners pay self-employment tax on the partnership income. One component of self-employment tax is the Social Security portion, which is computed on earnings up to $128,400 for 2018, and the Medicare portion, which has no upper limit.
Managing a partnership can be tough and there’s at least one legal downside of operating as a partnership. For instance, general partners are exposed to unlimited liability from lawsuits that arise in connection with the business even when they are based on the acts or omissions of a partner. This is to be contrasted with operating a business as a corporation where, as a general rule, only the corporation’s funds are at risk.
Fortunately, you do not have to forgo the tax advantages of operating as a partnership to limit your potential liability. You can operate as an S corporation to minimize your liability exposure and yet be taxed similarly (but not identically) to the way you would be taxed if you operated as a partnership. Another option is the limited liability company. With this choice, your liability exposure also would be reduced and you would be taxed even more like a partnership than if you operated as an S corporation.
If you’re considering starting a partnership, or any business, it’s best to consult your tax advisor before your sign any papers. They’ll be able to help you ensure that the business construct you use is going to be right for you.