Unlike corporations or limited liability companies (LLCs), partnerships can happen without actually creating them. It happens when you start making a product or providing a service, and then a friend or relative helps you out. At the time, you don’t really think twice about it, but come tax time, you realize you’re in business with someone. What now?
Here are 10 steps to make sure your partnership’s income or loss is reported and filed correctly. Once you’re done making sure your partnership’s filing is in tip-top shape, see our infographic below for a condensed version of what you need to file and when you need to do it.
Step 1: Get a Federal ID Number
Partnerships need to file partnership returns on Form 1065. To do that, the entity needs an Employer ID number, even if you’re not going to have employees. You can do it online at the IRS website. Follow the instructions carefully.
Incidentally, if you’re a husband-and-wife partnership, you have the option to report all the income on your personal tax return by filing two Schedule C’s. This is fine unless your partnership has payroll. Then it gets complicated.
Step 2: Define the Partnership Terms
While you don’t really need a written partnership agreement, it helps to put your arrangement in writing. As part of your agreement, you should define the following:
- Who is expected to perform each task, including sales, administration, production, customer service, public relations, the website, etc.
- Who is responsible for financial arrangements, including banking, borrowing, raising money, payroll (if applicable), hiring and tax matters.
- Each partner’s ownership portion. This is especially important if one person contributed money, while the other put in sweat equity or contributed assets. For partnerships, you can show three different types of splits on the tax return: capital ownership, profit sharing and loss sharing.
- How each partner is compensated for his or her work or services. Will it be based on the time devoted to the business? Will it be based on the contacts he or she brings in? Will it be based on commissions? Or on the licenses each brings to the partnership?
Putting all of this in writing beforehand can save both you and your partner(s) from legal and tax-related headaches. See our article for guidance on writing a solid partnership agreement.
Step 3: Open Up a Bank Account
It seems obvious, doesn’t it? But I run into many small partnerships that have just evolved without planning, and they are running the entire business out of the personal checking account of the senior partner.
Set up a separate checking account for the business. Shop around to find a bank that is friendly to you and your industry. And keep those personal transactions separate from your business transactions.
Step 4: Get Booked
Set up proper books. A QuickBooks Pro Advisor can set up your chart of accounts. The routine journal entries you should be making are:
- Reconcile loan balances
- Move interest payments to profit and loss statement (P&L), or move principal from the P&L to the balance sheet
- Enter depreciation for prior-year asset purchases
- Reconcile the partners’ capital and loan accounts
- Offset draws or advances with partners’ expense reports
- Reconcile the outstanding liability and asset accounts
To see all of the bookkeeping tasks you need to manage on a daily, weekly, monthly and yearly basis, see our accounting timeline and checklist.
Step 5: Mark Your Calendar
The calendar-year partnerships return, Form 1065, is due on April 15 each year (NOTE: For 2016, a holiday observance in Washington D.C. moves the due date to April 18). If you have a fiscal-year partnership, your due date is the 15th day of the fourth month after your year ends. For instance, if your fiscal year ends on July 31, you would have to file your tax return prior to November 15. (For 2016 tax returns onward, the due date is March 15, or three moths after fiscal-year end.)
Along with the Form 1065, each partner gets a Schedule K-1 (Form 1065), which shows the partner’s share of the partnership’s profits or losses, as well as certain other deductions or credits that are only reported on the partner’s personal tax return.
These K-1’s must be sent out by the due date of the partnership return. There are some heavy penalties for sending K-1’s late, so send out a preliminary set of K-1’s by April 15 (or 18th, this year, as the 15th falls on a holiday weekend).
To complete the K-1’s, you must have all the current information from each partner: name, mailing address, Social Security or taxpayer ID number, current year share of profits, loss and capital, and share of guaranteed income.
If you can, try to file early so that your partners can get their Schedule K-1’s early enough to file without an extension.
Step 6: File for an Extension, If Needed
For partnerships, use Form 7004 to file for an extension. As long as you file it on time, you will get an extra six months, automatically. Your extended due date will be September 15. For fiscal-year partnerships, the extension is sixth months after the original due date.
Step 7: Review Non-Federal Year-End Tax Obligations
Evaluate the tax expense account on your books. In addition to seeing what you paid and what is deductible, look to see what payments are missing, and take care of any obligations:
- File and pay, if applicable:
- Secretary of State fees (if you’re an LLC filing as a partnership)
- Personal property tax report
- Sales tax returns
- Payroll tax returns
- Personal estimated tax payments
- City/county/local business licenses
- 1099 forms to service providers (see our guide to filing 1099s for more info)
- Schedule K-1’s to partners
- Update, if applicable:
- Your mailing address with the IRS and state tax agencies
- Employee manuals
- Reimbursement policies
Step 8: Make Decisions, and Review Limits
When preparing a partnership tax return, make decisions about how to use deductions:
- What type of depreciation will you be using?
- Section 179
- Straight line
- Cost segregation
- If you use Section 179 depreciation, how will this affect the other partners’ personal tax returns? Some partners might have limitations that won’t let them use this deduction.
- Do you have bad debts you can write off?
- Do you have to make any elections to change asset values on your books?
Step 9: Is Your Income Too High?
As with corporations, you may still have some options, even after the year has ended.
Usually, the best strategy to take a big deduction is to make contributions to your retirement plan. If you didn’t have one open before the end of the calendar year, you may still open up a SEP-IRA and fund that to the limit.
Do you qualify for:
- Energy credits?
- Hiring credits?
- Childcare credits?
If so, you may be able to reduce your tax burden even further. Just be sure that whatever you claim is valid and can be supported with documentation.
Step 10: Be Aware of Tax Penalties
Tax penalties for partnerships are generally more steep than for individual filers, and they can grow out of control if left unaddressed. If you miss the tax filing deadline, you may be hit with one of three penalties. These include:
- Failure to File Penalty: The FTF penalty for partnerships is $195 for every month, multiplied by the number of partners, up to a maximum of 12 months.
- Failure to Furnish Timely Information: This penalty may be incurred if you either fail to furnish a Schedule K-1 to a partner, or if the Schedule K-1 you furnish has inaccurate information. The penalty for either is $260, with a maximum $3,178,500 for the calendar year. If you have been found to intentionally disregard the requirement for correct information, each $260 penalty is increased to $520 or, if greater, 10% of the aggregate amount of items required to be reported, and the $3,178,500 maximum doesn’t apply.
- Trust Fund Penalty: If your partnership is found not to have paid its anticipated tax bill, then a penalty amount equal to the bill will be applied.
When possible, make any and all income tax or estimated tax payments as soon as you can, since waiting will only add further penalty and interest charges.
Don’t run your business alone. Just as it takes a village to raise a child, it takes a team to grow a business. By having your tax pro and other key advisors in your corner, you won’t have to rely on trial and error. Your tax pro is more than a tax preparer. He or she is a wealth of information and can help you coordinate your books and succeed well beyond tax season.
For more tax tips, see our tax guides for small businesses for info on taxes for partnerships and other business entities. But before you go, don’t forget to download the partnership tax calendar infographic below to ensure you file all your required tax forms on time.