Selecting the type of business entity for a new business can be tricky. Sure, the internet is full of articles with basic definitions of the various business entities. But definitions don’t paint the full picture.
How you report your business income, when and how you pay taxes, and even how you pay yourself from the business can vary based on the business entity you select.
Forming a partnership
In our first blog post, we met Jane. She had just started a new business baking cookies and selling them online. Her business was a sole proprietorship because she hadn’t set up any formal entity (such as an LLC or a corporation).
One day, Jane met Michael. Michael was also a baker and made the best cakes Jane had ever tasted. Jane decided to go into business with Michael to expand the products she could sell in her online store.
Jane and Michael worked with an attorney to create a partnership agreement. But even without that agreement, if they didn’t do anything else to set up a formal entity, their business would be taxed as a Partnership by default.
Unlike a sole proprietorship, which reports all the revenues and expenses on the business owner’s personal tax return, a partnership has to file a separate tax return (Form 1065). The Partnership tax return will list all the revenues and expenses and calculate the business’s net profit (or loss).
The net profit (or loss) will be split between the partners and reported to them on a Form K-1. The partners use the K-1 to prepare their personal returns and report their share of partnership income. Let’s take a look at how it all works.
To form their new partnership, Jane and Michael each contributed $5,000 of their own money and opened a business bank account. In their first year, they sold $25,000 of baked goods. But, they also spend a significant amount of money updating the website and marketing their new products.
Overall, they spend $30,000 during the year, resulting in a net loss of $5,000. On their business tax return, they will split this $5,000 between them – and the partnership agreement should dictate how this loss is split. Jane and Michael decided to split all income and losses 50/50, so they each will get a K-1 showing $2,500 of losses. This $2,500 can offset other income on their personal tax returns.
Michael is married, and his wife makes over six figures at her job. Their joint tax rate is 40%. The $2,500 business loss would save him $1,000 in personal income taxes.
Jane is also married, and her husband earns modest wages. Their joint tax rate is $30%. At her rate, the loss would save her $750 in personal income taxes.
In year two, Jane and Michael doubled their sales to $50,000. Once again, they had expenses of $30,000, resulting in a net profit of $20,000. Since they agreed to split all income 50/50, they each received a K-1 showing $10,000 of business profit to report on their personal tax returns.
Keep in mind the partnership itself doesn’t pay any taxes. Form 1065 is simply used to calculate the business profit and split that between the partners. Each partner then pays income tax on their $10,000 partnership income.
The good news is that they qualified for the Qualified Business Income deduction. The QBI deduction allows you to reduce your business income by 20% – so only $8,000 of their $10,000 profit is taxed. At their tax rates (which stayed consistent with the prior year), Michael paid $3,200, and Jane paid $2,400.
Like a sole proprietorship, the partners also had to pay self-employment taxes. Self-employment taxes are similar to social security and medicare taxes you pay as an employee. Essentially, 92.35% of your net earnings from self-employment are subject to SE tax, and the SE tax rate is 15.3%.
Some quick math tells us that her SE taxes on $10,000 of profit is $1,413. You might notice that we don’t take the QBI deduction when calculating the SE tax – only when computing the income tax.
To add it all up, Jane will pay $2,400 in income taxes and $1,413 in SE taxes, while Michael will pay $3,200 in income taxes and $1,413 in SE taxes. All of these taxes will be calculated when they file their personal income tax returns.
Each partner is responsible for paying their own taxes. If the tax amount is small enough, it might be okay for Jane and Michael to wait until they file their tax returns to pay the extra taxes that are due.
The IRS has rules about how much of your taxes must be paid during the year (quarterly) and how much can wait until you file your taxes. If you leave too much to be paid after the end of the year, you risk being penalized for underpayment.
Another alternative is for Jane and Michael to make estimated tax payments during the year. Michael expects to have about $5,000 in extra taxes for the year because of his business income. So he can send payments of $1,250 each quarter to the IRS.
For Jane, at her lower tax rate, she expects closer to $4,000 in tax liability from her business income and sends $1,000 each quarter to the IRS. If they end up owing more when the actual taxes are calculated, they can pay the difference with their returns (or get refunds if they overestimated).
These estimated tax payments are due in April, June, September, and January every year.
Jane and Michael had $25,000 in their business bank account at the end of Year 2. They both agree it is time to start paying themselves out of this account. So how do they do that, and what are the tax consequences?
Remember, the partners are taxed on their portion of the profit in the business. Distribution of this profit to the partners does not change the profit calculation, so a distribution doesn’t affect the partners’ taxes.
The business can leave the entire $25,000 in the account to pay for future business expansion, or they could distribute $5,000 to each partner to help them pay for their additional taxes. Either way, the partners’ tax calculations would remain the same.
If their partnership agreement included a Guaranteed Payment, the outcome would be different.
With a Guaranteed Payment, a partnership would pay one (or both) of the partners a specific amount separate from the regular profit split. Let’s say Michael and Jane agreed to pay Jane $500 per month as a guaranteed payment for the extra work she does in the business.
That $6,000 per year to Jane would be an expense for the business but would also be reported separately as income on Jane’s K-1.
For year two, in the example above, Michael’s K-1 would show $7,000 in profit, and Jane’s K-1 would show $7,000 in profit and $6,000 in guaranteed payments. Michael would pay taxes on $7,000, and Jane would pay taxes on $13,000.
One Last Note on Partnerships
There are nearly 4 million active business partnerships in the US, based on 2019 tax returns. And while there can be many positives about not going into business alone, the business partners you choose and how well you work together will play a key role in the success (or lack thereof) of your business.
Get to know your partners before going into business, create a clear and detailed partnership agreement with the help of an attorney, and keep the lines of communication open at every stage of the partnership. For more information on forming a successful partnership, check out 7 tips for making a business partnership work, from score.org.
Stay tuned for more installments of our business entity blog series to dive into corporations and LLCs.
In the meantime, you might be interested in:
Business entity series part 1: sole proprietor
3 reasons bookkeeping is important year round
Getting things done (book club)