Suppose you’re a partner in a partnership where the agreement requires you to work some of the time for the business. Can you ever be treated as an employee of the partnership for tax purposes instead of as a partner? The lines may become blurry, but the IRS has maintained, at least up until this point, that partners aren’t employees.

New regulations concerning disregarded entities shed some light on this issue. Traditionally, the IRS has said that if you’re a partner who provides services to the partnership, you aren’t treated as an employee of the partnership. The regulations clarify that this result can’t be avoided if you become an employee, based on state law, of a single-member limited liability company owned by the partnership.

What is the tax significance? Unlike corporations, partnerships pass through items of income and loss to partners. You report the appropriate share on your personal tax return. Instead of receiving Forms W-2 as employees do, the partnership issues a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., to partners. In addition, you must pay income tax on guaranteed payments made during the year even though you don’t receive a taxable salary. Guaranteed payments are amounts paid to partners no matter the partnership’s income.

Similarly, although employment taxes aren’t deducted from wages, you pay equivalent self-employment taxes. The tax rate is double the usual rate for employees, but half of the amount is deductible on your return.

This tax structure can be problematic if fringe benefits are provided to workers. Because you, as a partner, aren’t treated as an employee, you generally aren’t eligible for the tax exclusion for certain statutory fringe benefits. That means the fringe benefit payments can represent taxable income to you.

Do you have questions about how your business ventures affect your tax return? Contact us for help.

 

Partnership Tax Terms and What They Mean:

Puzzled by tax-related partnership lingo? Here’s the definition of key terms in partnership tax rules.

• Compensation – Amounts paid to workers in exchange for services.

• Dividends – Distribution of business earnings.

• Guaranteed payments – Payments made to partners during the year regardless of whether the business is profitable.

• Schedule K-1 – The tax form used to report items of income, loss, and partnership activities to partners.

• Limited liability company (LLC) – A legal business entity, similar to a partnership, where the members have no personal obligation to pay company debts.

• Partner – One of the individual parties in a partnership.

• Partnership – An unincorporated business made up of two or more entities who engage in an activity for profit. Income and loss of the partnership are passed through to the partners. For tax purposes, a partnership may differ from a joint venture, which is generally a joint undertaking to share expenses.

• Partnership agreement – A legally binding agreement between partners detailing the business relationship. Amendments are considered part of the original agreement.