U. S. Taxation: Partnership Firms– LLC & others– Series No. 1
It is a common debate among accounting professionals that Partnership firms in U.S.A. would solve all the problems and that they would recommend their clients to have the
same structure for business. With NRI friends with foreign experience, the concept of LLC or LLP has taken a deep root. Like the kid one day asked me about the partnership firm in my garden, do we have the required information on Partnership firm’s formation, the rules, tax
information or dissolution, with reference to United States taxation rules duly formed by Internal Revenue Service? You are likely to be interfaced with above under the following pages. My simple request is to learn the rules, enjoy mentally forming them but leave it to a qualified professional like a CPA from USA to handle it on your/your clients’ behalf for tax purposes.
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 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
A Limited Partnership is formed under a State Limited Partnership law and obviously has one general partner and one or more limited partners.
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 a practicing Chartered 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 Joint Venture Election.”
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. The writer of this article has given detailed coverage of
Schedule C of form 1040 when he wrote some time back, an article on understanding
individual tax under U.S. Taxation in Tax Guru. 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 be presumed.
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 is not difficult to fathom.
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 since many brilliant writers have covered India in the past regarding Partnership Taxation.
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. The writer has apparently emphasized the fundamental understanding of form 1040 frequently because of this reason.
Why not get into an example, just for fun?
Let us assume the child which started my discussion in one of my earliest articles on Form 1040 forms a partnership firm with his spouse and start producing cars. His distributive share of profit from his firm is $6.5 million 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
Self-employment tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners.
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 2010 Tax Relief Act reduced the self-employment tax by 2% for self-employment income earned in calendar year 2011. The self-employment tax rate for self-employment income earned in calendar year 2011 was 13.3% (10.4% for Social Security and 2.9% for
Medicare). The Temporary Payroll Tax Cut Continuation Act of 2011 extended the self- employment tax reduction of 2% for calendar year 2012 so the rates for 2011 remained in effect for 2012. For self-employment income earned in 2013 and 2014, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
This means that in 2016 a self–employed person’s net income up to $118,500 will have a FICA tax of 15.3% (the 12.4% of Social Security tax plus the 2.9% of Medicare tax). The amount in excess of $118,500 will be subject to the 2.9% Medicare tax. There is also a Medicare surtax that applies to higher income taxpayers.
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. For tax years for 2015 or earlier, the filing deadline is 15th day of fourth month of the year after the tax year. Obviously, for a calendar year partnership firm it was 15th April.
However, after December 31, 2015, it has been changed into the third month of the next tax year. For a calendar year, it is March 31. For the tax year 2016, it is March 31, 2017.
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. Page 2 and 3 consist of
Schedule B with 22 items.
Page 4 consists of Partners’ distribution share items which consist of 20 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 5 consists of analysis of net income, 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.
Conclusion
The author started the discussion on partnership firms in U.S.A., with various types of partnership firms that exist, their formation, tax year, last date for filing of tax returns, details of Form 1065, and various pages of the form for general information. As initiated in the beginning, one of the easiest formation of any body is the partnership firm in U.S.A., but due to utter carelessness or lack of professional follow up, many partners from India have lost their income or failed to account professionally their legally lawful deductions. Failing to use professionals like C.P.A., lawyers or others contributed towards to their difficulties. The author intends to continue the discussion further in future articles for knowledge. Definitely, this will not solve their professional requirements. Why not leave the professional tax work to a qualified and experienced C.P.A. from U.S.A.?
References
https://www.irs.gov/pub/irs-pdf/f1065.pdf irs.gov/pub/irs-pdf/i1065.pdf
IRS publication 541, Partnerships
Self-employment Tax – website address given below. https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax- social-security-and-medicare-taxes
Most authoritative book on U.S.A., Tax book by Tax Materials, Inc, Minnetonka, MN 55435 (millions of CPAs like the author invariably refer this book for ready reference, other than IRS materials and are thankful to these brilliant publications)
About the author: Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in
international tax, auditing, IFRS etc., he continues his practice in New Delhi, India. He can
be reached at [email protected] Tel: 7503562701, 9015613229. He currently lives in Delhi.
His name appears as tax consultant in web site of American embassy, New Delhi. He is thankful to various suggestions received from readers and is delighted to feel the enthusiasm of readers.
