Partnership Taxation
A partnership is the relationship between two or more entities who join together to carry on a trade or business. An entity, when used in this context, may refer to an individual, a corporation, a trust, an estate or another partnership.
For federal tax purposes, the term “partnership” includes a syndicate, group, pool or joint venture that is carrying on a trade or business and is not classified as a trust, an estate, a qualified joint venture, or a corporation.
Per se corporations, such as insurance companies, cannot be classified as partnerships, tax-exempt organizations cannot be classified as partnerships, a domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax purposes.
A partnership that conducts a service business, such as accounting, law or medicine, is usually established as either a general partnership or a limited liability partnership.
A general partnership consists of two or more general partners. Creditors of a general partnership can collect amounts owed to them from both the partnership assets and the personal assets of the owner-partners. A general partner can be bankrupted by a malpractice judgment brought against the partnership, even though the partner was not personally involved in the malpractice.
An LLP is a recently created form of entity. In most states, owners of an LLP are treated much like general partners. The primary difference between an LLP and a general partnership is that an LLP partner is not personally liable for any malpractice committed by the other partners. The LLP is currently the operational form of choice for the large accounting firms.
A limited partnership is often used for acquiring capital in activities such as real estate development. A limited partnership has at least one general partner and often may limited partners. Typically, only the general partners are personally liable to creditors; each limited partner’s risk of loss is restricted to that partner’s equity investment in the entity.
An alternative entity form, the limited liability company (LLC) is available to all states and the District of Columbia. An LLC combines the corporate benefit of limited liability for the owners with the benefits of partnership taxation, including the single level of tax and special allocations of income, losses and cash flows. Owners are technically considered to be members rather than partners, but a properly structured LLC is treated as a partnership for all tax purposes. Almost all states permit capital-intensive companies as well as nonprofessional service oriented businesses and some professional service-providing companies to operate as LLCs. This is highly advantageous to a business entity since the LLC can protect each member’s personal assets from being exposed to the entity’s debts.
The unique tax treatment of partners and partnership can be traced to two legal concepts that evolved long ago, the aggregate concept and the entity concept. Aggregate concept treats the partnership as a channel through which income; credits, deductions and other items flow to the partners.
The entity concept treats partners and partnership as separate units and gives the partnership its own tax personality. A partner’s recognition of capital gain or loss on the sale of the partnership interest further illustrates this doctrine.