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Welcome back the third of our 4-part series, where we continue the discussion of how business owners can withdraw money from a business and the tax impact. Previously we reviewed the classification and structure of transactions and secondly how sole proprietors should streamline their efforts regarding bank account activity and how to best pay themselves. In this month’s blog, we review the impact on partnerships.

Wages are not suitable for owners of partnerships or sole proprietorships. The IRS does not allow owners of partnerships to take a payroll wage (W-2) from a partnership. “Guaranteed payments” to partners are the partnership counterpart to W-2 payroll wages. I have always cringed at the term “guaranteed payment” when talking to partners because the phrase just doesn’t make sense to me. But, it’s the term we have been given from the IRS so we will go with it. A partner has two ways to pull money out of a partnership and get paid; a partner can take a “guaranteed payment” for services rendered and time worked or a partner can take a Partner Draw of Equity from their prorata share of the profits from a partnership. If a partner takes a Draw of Profits from a partnership then ALL the partners have to pull out profits at the same time based on the percentage of ownership.

Technically, a partner is taxed on their “guaranteed payment” and their prorata share of profits. This is a very important distinction to make so read closely! A partner is taxed on the profits of the business NOT on their draw of the profits. That may sound like the same thing but it is very different. For example, lets say a Partnership has profits of $100,000 but the partners have only taken draws from profits of $50,000. Even though the partners have not pulled all of the profits from the business, they will be taxed on the full amount of the profits or the $100,000 in this case. This can be a shocker to a partner at tax time!

One major difference between with “guaranteed payments”, there is no withholding for payroll taxes of income tax. These amounts are computed and paid on the partner’s individual Form 1040.

Income from partnerships flows through to the partner’s individual tax return. Flow through income is reported without regard for whether or when the income is distributed as a draw of profits, to the partner, like I mentioned above. The partner will pay tax on their personal return on the amount of profits from the partnership and the amount of “guaranteed payments” received. There is NO withholding on this income so a partner must pay Quarterly Estimated Tax payments to the Fed and State on their income.

One final point: A partnership can receive loans from partners, and on the other hand a partnership can make loans to partners. There is generally no taxable event when a partnership repays a loan from a business owner, and no taxable event when a partnership makes a bona-fide loan to a partner. However, failure to adhere to necessary formalities can put these transactions in danger allowing the IRS to step in and reclassify the transactions, resulting in taxable income for the business owners.

Next month, tune in for the final part of our 4-part series, where we discuss the impact of taking money out of a business that is structured as an S corporation.

Business owners should follow the advice of a tax professional to make sure financial transactions are controlled and do not cause unanticipated taxation or other negative effects. Feel free to contact Jason Bailey or myself with any questions.


Article from TheTaxBook

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Blog by Kim Storen, EA – Tax Team Lead, Senior Tax Professional

Learn more about Kim and the rest of the Storen Financial team here.