If you are a partner in a partnership, are you wondering how your income from the partnership is taxed? This article will answer that question.
By “partner”, I’m referring to someone who is in business with at least one other person and you’ve agreed to share in the profits and/or losses of the business. A partnership files its federal annual income tax return on Form 1065 due April 15 each year.
By “partner” I’m also referring to owners of a limited liability company (LLC) who have not chosen to be taxed as a corporation. By default, a multi-member LLC is taxed as a partnership and will also file Form 1065 annually.
Now to the question at hand: How are these partners or LLC members taxed?
You are not treated as employees. Partners and/or LLC members are not paid wages or salaries. So do not withhold income taxes or payroll taxes (such as Social Security and Medicare taxes) from your compensation. At the end of the year, you will not receive a Form W-2.
Of course, should you have other non-owner staff who are being paid as employees, you should definitely issue paychecks to them, withholding the appropriate income taxes and payroll taxes, and giving them a W-2 at the end of the year. But never treat yourself as an employee.
Instead of receiving a W-2, the partners and LLC owners receive a Schedule K-1 from the business at the end of the year. This K-1 is part of the partnership federal income tax return and reports each owner’s share of the business profit or loss. Should the business have a profit, this profit is then reported on the partners’ personal income tax return via Schedule E (page 2) of Form 1040, where it is subject to both income tax and self-employment.
So there’s a sense in which the partnership owners are treated as sole proprietors for federal tax purposes. This is because not only do the partners pay federal income tax on the K-1 income, but they must also pay self-employment tax. Each partner’s share of partnership income must also be reported on Schedule SE of Form 1040, which is the form used to calculate self-employment tax, the self-employed person’s version of Social Security and Medicare taxes.
Should the partnership have a loss, the partner’s share of that loss is also reported on Schedule K-1, and that loss is then transferred to partner’s personal tax return, where it is generally deducted against other sources of income.
One final comment: depending on the K-1 income amount, partners and LLC members generally must make federal quarterly estimated tax payments. Be sure to check with your tax professional to determine the amount of those payments. Failure to make them can result in penalties for underpayment of estimated tax payments.