Whether it’s two professionals working to run a more profitable enterprise, chiropractors in a joint venture, or a group or pool with others, partnerships are an increasingly popular type of business entity.
In fact, they rank just behind S corporations as the most common. Unfortunately, while partnerships aren’t usually required to pay taxes, they and other pass-through practice entities were caught up in the recently passed tax reform rate controversy.
The basic concept of a partnership is that all profits and losses flow through to the partners, who are then responsible for paying taxes. In essence, partnerships are unincorporated businesses or joint ventures with two or more partners. Because partnerships are unincorporated, the IRS does not tax them directly. Instead, profits that flow to the partners are taxed as their income.
Although a partnership does not pay taxes on its profits, it is required to report its operating losses or profits to the IRS on Form 1065, U.S. Return of Partnership Income. The partnership must also send Schedule K-1 forms to partners, alerting each to their share of profits or losses, to be reported on their tax returns.
There are three general types of partnership arrangements:
General partnerships, where profits, liability and management duties are divided equally among all partners. If an unequal distribution is made, the percentages assigned to each partner must be documented in the partnership agreement.
Limited partnerships allow partners to have limited liability as well as limited input in management decisions. These limits depend on the extent of each partner’s investment percentage. Although more complex than general partnerships, limited partnerships are attractive to investors in short-term projects.
Joint ventures are usually classed as general partnerships, but for only a limited period of time or for a single project. Partners in a joint venture can be recognized as an ongoing partnership if they continue the venture, but they must file as such.
A chiropractic partnership must register with the IRS as well as with state and local revenue agencies to obtain a tax ID number or permit. Once formed, a partnership “passes through” any profits or losses to its partners.
Whether or not each partner actually receives the amount stated on the Schedule K-1 filed by a partnership is irrelevant. The IRS levies taxes based on a partner’s “distributive share,” which is the percentage of the practice’s profits distributed to the partner. If, for example, the partnership agreement states that a certain percentage of the profits should stay within the partnership (e.g., to pay for expansion or overhead), it doesn’t matter to the IRS. Their focus is on what each partner’s share ought to be. Otherwise, partnerships could retain profits to avoid paying taxes.
The Tax Cuts and Jobs Act
While the income of an incorporated practice (or business) will be taxed at a flat 21-percent tax rate under the Tax Cuts and Jobs Act (TCJA), the pass-through income of a partnership may be taxed at the reduced, but still higher, individual income tax rates.
Beginning in 2018, the TCJA created a 20-percent deduction that applies to the first $315,000 (one-half that amount for single filers) of income passed through to the practice’s partners. For practices with pass-through income above this level, the new law contains strong safeguards to ensure that wage income does not receive the lower marginal effective tax rates of business income.
Thus, that 20-percent deduction applies only to the passed-through income of a practice that has been reduced by the amount of “reasonable compensation” paid to the owner. “Reasonable” compensation has not been defined as yet.
Other partnership taxes
Partners are considered to be self-employed, not employees, and required to file a Schedule SE with their Form 1040 and pay self-employment taxes. This amount is the “reasonable compensation” required of profitable pass-through entities.
Because of this self-employed status, each partner is also responsible for paying his or her share of Social Security taxes and Medicare. Partners are responsible for paying double what a normal employee would pay (because employers normally match employees’ contributions). Of course, the partners’ tax burden is reduced by an allowance for one-half of the self-employment tax that can be deducted from taxable income.
Before venturing into a partnership arrangement of any type, have a clear understanding of the advantages offered by this corporate structure.
Easy and inexpensive: Partnerships are generally an inexpensive and easily formed business structure.
Shared financial commitment: In a partnership, each partner is equally invested in the success of the practice. Partnerships have the advantage of pooling resources to obtain capital, often beneficial when seeking credit.
Complementary skills. A good partnership will usually benefit by capitalizing on the strengths, resources and expertise of each partner.
Partnership incentives for employees. Offering employees the opportunity to become a partner can be an advantage in attracting highly motivated and qualified employees to any chiropractic practice.
Disadvantages of a partnership
Most business decisions have pros and cons, and the choice to form a partnership is no exception. The following are some drawbacks or features of partnering that should be weighed carefully.
Joint and individual liability. Partners are not only liable for their own actions but also for the debts and decisions of the other partners. What’s more, the personal assets of all partners can be used to satisfy partnership debt.
Disagreements among partners. Especially when there are multiple partners, disagreements are common. Partners should consult each other on all decisions, make compromises, and resolve disputes as amicably as possible.
Shared profits. Because partnerships are jointly owned, each partner must share the successes and profits of the practice or venture with the other partner(s). Unequal contributions of time, effort or resources often results in discord among partners.
Partnerships and audits
The Bitpartisan Budget Act of 2015 (BBA) repealed the old rules governing partnership audits, replacing them with a new, centralized partnership audit regime. The IRS now assesses and collects tax at the partnership level. In fact, the IRS recently proposed regulations addressing how partners with pass-through income account for adjustments such as underpayments that have been corrected at the partnership level.
Not only can the IRS now conduct audits of large partnerships at the partnership level rather than at the individual partner level, they can assess and collect tax at the partnership level. Interest and penalties will also be applied at the partnership level because of the BBA.
Limited liability partnerships
A limited liability partnership, or LLP, is a fairly new entity for operating a practice that provides increased liability protection for partners. Technically, an LLP is not a different practice structure than a standard partnership. In general, an LLP can be a general or limited partnership and is treated similarly for tax purposes.
A LLP extends the liability protection of a limited partner to that of a general partner. Typically, a general partner in an LLP is not liable for debts and obligations stemming from errors, negligence or misconduct committed by another partner, employee or agent of the practice unless the general partner had knowledge of it. But a general partner is still liable for other partnership debts as well as for his or her own actions.
Despite the similarity in name, an LLP is not a limited liability company (LLC). A general or limited partnership needs to register with the state, but the registration does not change the entity of the partnership.
An LLP does not have the structure of an LLC, and does not have the tax flexibility enjoyed by an LLC when choosing whether to be taxed as either partnership or a corporation. That choice can offer tax advantages to a LLC, depending on the practice’s specific circumstances. An LLP, however, can only be taxed as a partnership.
Changing your mind
Fortunately, application of the partnership tax rules can be avoided in some cases where the income of the partners can be adequately determined without partnership-level computations and in the case of certain husband-wife partnerships. What’s more, many entities that qualify for partnership treatment may qualify for opting out of that status under the so-called “check-the-box” regulations.
An entity with two or more members can be classified either as a partnership or as an “association” taxed as a corporation. In fact, any entity not required to be taxed as a corporation for federal tax purposes may choose its own classification. Naturally, professional assistance may be required to take full advantage of a chiropractic practice partnership or joint venture—and avoid the many potential pitfalls.
Mark E. Battersby, Esq., is a tax and financial adviser, freelance writer, lecturer, and author located in Philadelphia. He can be reached at 610-789-2480.
Disclaimer: The author is not engaged in rendering tax, legal, or accounting advice. Consult your professional adviser about issues related to your practice.