Register partnerships with the Internal Revenue Service

Partnerships pay no taxes on their profits, but they must still report operating losses or profits to the IRS.

Issue: August 2015

ByMark E. Battersby

Whether it is two professionals working to run a more profitable enterprise, optometrists or optometry practices in a joint venture, a syndicate, a group or pool with others, partnerships are an increasingly popular entity. In fact, partnerships rank just behind S corporations as the most common type of business entity. Unfortunately, while partnerships are not usually required to pay taxes, the reporting requirements and complexity of the tax laws have led many professionals astray.

The basic concept of a partnership is that all profits and losses flow through to the partners, who are then responsible for taxes. In essence, partnerships are unincorporated businesses or joint ventures with two or more partners. Because partnerships are unincorporated, the Internal Revenue Service does not tax them directly. Instead, profits that flow to the partners are taxed as their income.

Although a partnership does not pay taxes on its profits, it must report its operating losses or profits to the IRS on Form 1065, U.S. Return of Partnership Income. The partnership must also send Schedule K-1 to partners alerting each to their share of profits or losses, with these amounts reported on the partners’ income tax returns.

Typecasting partnerships

There are three general types of partnership arrangements: general partnerships, limited partnerships and joint ventures.

With general partnerships, profits, liability and management duties are divided equally among all partners. If an unequal distribution is made, the percentages assigned to each partner must be documented in the partnership agreement.

Limited partnerships allow partners to have limited liability as well as limited input in management decisions. These limits depend on the extent of each partner’s investment percentage. Although more complex than general partnerships, limited partnerships are attractive to investors in short-term projects.

Joint ventures are usually classed as general partnerships, but for only a limited period of time or for a single project. Partners in a joint venture can be recognized as an ongoing partnership if they continue the venture, but they must file as such.

The bottom line is that partnerships can take a variety of forms, and partners can be individuals, professional corporations, S corporations, limited liability companies (LLCs) or a mix.

Partnership taxes

An optometry partnership must register with the IRS as well as with state and local revenue agencies to obtain a tax ID number or permit. Once formed, a partnership “passes through” any profits or losses to its partners.

Whether or not each partner actually receives the amount stated on the Schedule K-1 filed by a partnership is irrelevant. The IRS levies taxes based on a partner’s “distributive share,” which is the percentage of the practice’s profits the partner is entitled to.

If, for example, the partnership agreement states that a certain percentage of profits should stay within the partnership (e.g., to pay for expansion or overhead), it does not matter to the IRS. Their focus is on what each partner’s share ought to be. Otherwise, partnerships could retain profits to avoid paying taxes.

The distributive share of each partner is usually determined by the partnership agreement. In the absence of a written partnership agreement, profits are usually split evenly. For instance, if the partnership agreement for an optometry practice states one partner will receive 70% of the profits and losses, with another partner allocated the remaining 30%, then that 70/30 split will represent each distributive share. Without a written agreement – or without what the IRS labels a “special allocation” – each distributive share is automatically 50% of profits and losses.

Special allocations

It is only when a partnership has made a Code Section 754 election, a so-called “special allocation,” that the tax rules permit adjustments. In general, a 754 election permits adjustments to a partner’s share of the tax basis of the partnership assets, referred to as the “inside basis,” so that it is equal to the tax basis of the partner’s partnership interest, referred to as the “outside basis.” If no 754 election has been made, no adjustments can be made to the inside basis of partnership assets unless mandatory adjustments are required by the IRS.

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Other partnership taxes

Not too surprisingly, there are several tax issues partners must consider. Partners, for example, are considered to be self-employed, not employees, and required to file a Schedule SE with their Form 1040 and pay self-employment taxes.

Because of this self-employed status, each partner is also responsible for paying his or her share of Social Security taxes and Medicare. Partners are responsible for paying double of what a regular employee would pay (because employers normally match employees’ contributions). Of course, the partners’ tax burden is reduced by an allowance for half of the self-employment tax that can be deducted from taxable income.

Advantages of partnerships:

Easy and inexpensive. Partnerships are generally an inexpensive and easily formed business structure.
Shared financial commitment. In a partnership, each partner is equally invested in the success of the optometry practice. Partnerships have the advantage of pooling resources to obtain capital, often beneficial when seeking credit.
Complementary skills. A good partnership will usually benefit by utilizing the strengths, resources and expertise of each partner.
Partnership incentives for employees. Offering employees the opportunity to become a partner can be an advantage in attracting highly motivated and qualified employees to any optometry practice.

Disadvantages of partnerships:

Joint and individual liability. Partners are not only liable for their own actions, but also for the debts and decisions of the other partners. In addition, the personal assets of all partners can be used to satisfy partnership debt.
Disagreements among partners. With multiple partners, disagreements are common. Partners should consult each other on all decisions, make compromises and resolve disputes as amicably as possible.
Shared profits. Because partnerships are jointly owned, each partner must share the successes and profits of the practice or venture with the other partners. An unequal contribution of time, effort or resources often results in discord among partners.

Limited liability partnerships

A limited liability partnership, or LLP, is a fairly new entity for operating an optometry practice that provides increased liability protection for partners. Technically, a LLP is not a different practice structure than a standard partnership. In general, a LLP can be a general or limited partnership and is treated similarly for tax purposes.

A LLP extends the liability protection of a limited partner to that of a general partner. Typically a general partner in a LLP is not liable for debts and obligations stemming from errors, negligence or misconduct committed by another partner, employee or agents of the optometry practice unless the general partner had knowledge of it. A general partner is, however, still liable for other partnership debts as well as for his or her own actions.

Despite the similarity in name, a LLP is not a limited liability company (LLC). A general or limited partnership needs to register with the state, but the registration does not change the entity of the partnership. A LLP does not have the structure of an LLC and does not have the tax flexibility enjoyed by an LLC when choosing whether to be taxed as either a partnership or a corporation. That choice can offer tax advantages to a LLC depending on the practice’s specific situation. A LLP, however, can only be taxed as a partnership.

Passive loss

As mentioned, a partnership must file an annual information return to report its income and losses even though it does not pay income tax. Instead, it passes through any profits or losses to its partners, with each partner showing such profits or losses on their individual income tax returns. Loss deductions can be claimed – but only for amounts that do not exceed the book value of their investment in the practice. Losses where the partner is more of an “investor” are another story.

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A passive loss is defined as a loss resulting from an investment in an enterprise in which the investor does not “materially participate.” To be considered a nonmaterial participant, the investor cannot be continuously and substantially active or involved in the activities of the practice or business.

Passive losses can only be written off or used to offset passive gains. When losses exceed the income from passive activities, the remaining loss can be carried forward to the next tax year, provided there is some passive income to write it off against.

Changing your mind

Fortunately, application of the partnership tax rules can be avoided in some cases where the income of the partners can be adequately determined without partnership-level computations and in the case of certain husband-wife partnerships. In addition, many entities that qualify for partnership treatment may qualify for electing out of partnership treatment under the so-called “check-the-box” regulations.

An entity with two or more members can choose to be classified either as a partnership or as an “association” taxed as a corporation. In fact, any entity not required to be taxed as a corporation for federal tax purposes may choose its own classification. Naturally, professional assistance may be required to take full advantage of an optometry practice partnership or joint venture – and to avoid the many potential pitfalls.

References:
Subchapter K – Partners and Partnerships. Sections 701 through 761 of the U.S. Tax Code (Subchapter K). http://uscode.house.gov/view.xhtml?path=/prelim@title26/subtitleA/chapter1/subchapterK&edition=prelim. Accessed June 10, 2015.
Internal Revenue Service. Partnerships. http://www.irs.gov/publications/p541/. Accessed June 10, 2015.
Internal Revenue Service. Partnership – Audit Technique Guide – Overview. http://www.irs.gov/Businesses/Partnerships/Partnership-Audit-Technique-Guide-Overview-%28Published-12-2002%29. Updated November 5, 2014. Accessed June 10, 2015.

For more information:
Mark E. Battersby has been reporting on news and developments in the tax and financial arenas for more than 25 years. He can be reached at MEBatt12@Earthlink.net.

Disclosures: Battersby has no relevant financial disclosures.