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Tax Structure and Liability of Business Partnerships

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  • 0:08 Partnerships
  • 2:03 Partnership Taxes
  • 3:41 Personal Liability
  • 5:48 Lesson Summary
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Lesson Transcript
Instructor: Ashley Dugger

Ashley is an attorney. She has taught and written various introductory law courses.

Many businesses are partnerships. These are unincorporated businesses owned by two or more people. This lesson explains the tax structure of partnerships and the liability of general partners.

Partnerships

Partnerships are one of the easiest and least expensive business structures to form. A partnership is an unincorporated, for-profit business established and run by two or more individuals. The individuals are known as 'partners' and serve as co-owners of the business.

There are several types of partnerships, but the most common is the general partnership. This is a business partnership where all partners have responsibility for the business and unlimited liability for business debts. Each general partner is responsible for the business in some way. This means that each partner must contribute something to the partnership, such as funds, property, skills or labor. Each general partner shares the business profits, liabilities and losses.

For example, let's say that Dottie and Dave decide to open a clothing store. Their store will be called D.D.'s Duds. Dottie and Dave are general partners. The two decide that Dottie will be responsible for buying the clothing and stocking the store. Dave will be responsible for everyday store operations. They'll both contribute money toward funding the store, and they'll split any profits. If the store loses money, then they'll split the losses. As general partners, each has the power to manage some aspect of the business.

Partnerships generally provide one main advantage and one main disadvantage. The main advantage is that the partnership isn't separately taxed. The main disadvantage is that general partners have unlimited liability for partnership obligations. Let's take a separate look at these unique qualities of a business partnership.

Partnership Taxes

One advantage of a partnership is that it isn't separately taxed. The IRS doesn't treat the partnership as a separate tax entity. In this way, it's treated the same as a sole proprietorship rather than like a corporation.

This means that the business profits aren't taxed. Instead, the profits flow through or pass through to the partners. The business profits become the partners' income. The partners then file their own tax returns and pay income tax on their individual income.

For example, let's say that Dottie and Dave agree to split all business profits 50/50. The business makes $100,000 net profit in its first year. Dottie takes $50,000 for her income, and Dave takes $50,000 for his income. D.D.'s Duds won't pay taxes on its $100,000 profit. Instead, Dottie will pay income taxes on her $50,000 share, and Dave will pay income taxes on his $50,000 share.

Keep in mind that although the partnership doesn't pay taxes, it must still comply with IRS requirements. All partnerships are required to file an informational tax return with the IRS each year. The IRS then balances this informational return against the tax returns of each partner in order to ensure correct income reporting by each partner.

Personal Liability

Now let's take a look at the one main disadvantage of general partnerships. The main disadvantage is that all partners can be held personally liable for all business debts and liabilities. This includes financial obligations and court judgments.

For example, let's say that Dottie ordered $10,000 worth of Josie's Jeans to sell in the store. Josie's sends the jeans and a $10,000 invoice. The jeans don't sell, so D.D.'s Duds doesn't have the money to pay Josie's invoice.

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