Formation of partnerships should be considered only after respective partners have a full understanding of the potential tax implications.
All income or losses flows through from the U.S. partnership tax return form 1065, to each partner’s respective individual form 1040 return. Basis issues must be adhered to, meaning the amounts loaned to/invested in the partnership must be used to determine profit and loss sharing splits to the partners. This can have a dramatic impact on a taxpayer if he is in a high tax bracket, for example, and assuming he is a 50% partner (and therefore has loaned to/invested in the partnership), would need to report half of the partnership’s income on his form 1040.
In virtually all cases, a limited liability partnership type is more advantageous than that of a general partnership (in the former, the liability is limited for limited partners within the entity, and only the general partner is exposed to liability. The later exposes all partners to general liability). These are legal issues, and, of course, a qualified business attorney should be consulted before setting these agreements up.
These rules are complex, and like LLCs should be discussed with me before a decision on entity selection is made.
Limited Liability Companies (LLCs)
A great deal of interest has been generated recently regarding this type of entity. There are several key advantages to a limited liability company. As the name implies, limitation of liability is one of them, since members or managers (the owners of the company) are generally protected from lawsuits and various other civil claims in the event of default, etc. These of course are legal issues, and should be discussed with a qualified attorney before making an informed decision regarding entity selection. Florida permits their use, and each state has its own rules regarding limited liability companies (LLCs). Rules become even more complex, with the recent advent of “series LLCs”.
From a tax point of view, there is the advantage of “basis” (or owner’s interest) flexibility regarding income/loss splitting among the owners. For example, this simply means the owners may decide how best to split the income regarding profits and losses, and don’t need to concern themselves with keeping their respective investments in the company aligned with each of their desired profit and loss splitting percentages and thus income or loss amounts. These percentages may be changed each year depending upon prevailing owners’ tax circumstances such as amounts of contributed capital into the LLC. However, certain rules must be followed regarding establishment of each member’s basis in the LLC.
Another advantage is that losses from an LLC can be utilized to reduce self-employment tax (social security tax) as well as income tax. The company’s assuming general partner-like liability in order for this to be effective.
Income (or losses) are reported on the respective LLC tax return (usually U.S. Partnership form 1065, unless an election to be taxed as a corporation is made) and would flow through to the owners’ 1040 tax returns typically as if they were partners in partnership. If the company instead elects to be taxed as a corporation instead of a partnership the taxability would be to the corporate standalone entity (after which an “S” corporation election could be made, and income could then flow through to the members the same way as that of a partnership entity). The rules are becoming increasingly complex, due to I.R.S./tax court decisions offering precedence as a practical basis in interpreting and applying the LLC tax legislation. For a detailed discussion, contact this office at 561-989-9900.