Tax Treatment
Although S-corporations and partnerships are both passthrough entities, partnerships have the unique availability of special allocations to partners. For example, a partnership agreement may allocate all of the depreciation deductions to one partner subject to limitations. Additionally, a partnership agreement may specify that the partners may share capital, profits, and losses in different ratios. Stated differently, the sharing of profits does not have to coincide with the sharing of losses.
Because of the flexibility inherent in Subchapter K, partnership agreements can be written to reflect whatever economic sharing arrangement and risk sharing arrangement the parties wish to execute. For example, Partner A, who has skills, goes into business with Partner B, who has capital. Partner B contributes $100,000 in cash. A and B agree to split the business profits 20/80 until B recovers his entire investment; thereafter profits are split 50/50. Special allocations permit partners to assume different levels of risk and to set the timing of income in accordance with their preferences.
Such flexibility comes with strings attached. Partners are not able to allocate tax benefits among themselves in a manner that is divorced from their allocation of economic profit or loss. A partner who is economically enriched by an item of partnership income or gain is required to shoulder the associated tax burden. Similarly, a partner who is economically hurt by an item of partnership loss will be allocated the tax benefit of the loss. The tax allocations must ultimately conform to the economics of the partnership's transactions.
Considering all of the basis and allocation rules, partnerships can become quite complex, but for certain situations they can bring together people who have vastly different things to offer and give them a viable and fair format to do business.
One more consideration whether to use the general partnership format is the knowledge that each general partner is subject to paying their own self-employment (Social Security/Medicare) taxes. Up to 15.3 percent of his or distributive share of the partnership income will be added to the partners personal tax return to cover this tax. It thus becomes the responsibility of the partner to make estimated tax payments quarterly (Form 1040-ES) to cover the projected tax liability to avoid penalties.