A partnership, for tax purposes, is defined by negative implication. It is a “joint venture” or similar organization engaged in business that is not classified as a trust, corporation or estate. Partnerships, unlike corporations, generally pay no income taxes. Taxes are instead paid by the partners, who are taxed on their share of partnership income, deductions and losses.
A partner’s “share” of partnership income, deductions and losses is defined as the partner’s “distributive share” of those partnership items. This distributive share is in turn determined by reference to the partnership agreement. Thus, one of the attractive aspects of the partnership form becomes immediately apparent: The partners, themselves, can determine to a large extent what taxes will be paid by whom, since they themselves draft the partnership agreement with its provisions allocating distributive shares.
One sizeable constraint upon the partners’ liberty to themselves determine their tax fate through the partnership agreement lies in the requirement that allocations comport with economic reality. Thus, two partners could not, consistent with this rule, each contribute $10,000 to an oil venture and allocate all of the losses to one partner and all of the income (if any) to the other.
Another attractive feature of the partnership form is the ability of the partnership to generate losses which can be currently utilized by its partners. (In contrast, shareholders of a C corporation cannot deduct the corporation’s losses for the year. Before they can realize any of the corporation’s losses, such shareholders must actually sell their interest in the corporation.) This characteristic often makes the partnership form a good vehicle for the traditional tax shelter, where large losses are expected in the early years. If the venture later turns profitable, the entity can be changed to a corporation. At that point, the partners would no longer be taxed on their distributive share of income; of course, the corporation would itself be required to pay income tax at that point.
Note well: A partner’s allowable “distributive share” of partnership losses cannot exceed his “basis” in the partnership interest. Basis, however, is defined as the partner’s capital contributions to the partnership plus his share of the partnership’s liabilities. In contrast, a shareholder’s basis in a corporation includes capital contributions, but not loans incurred by the corporation.
Deciding whether to operate a business as a partnership requires that the taxpayer also consider the nontax consequences attendant upon his or her choice of business form.
A partnership will usually have a closer nexus to its partners than does a corporation to its shareholders. Consequently, just as the income and losses of the general partnership flow out to the partners, so too do the obligations and debts. Unlike shareholders of a corporation, general partners are in a very real sense personally liable for the partnership’s obligations, if the partnership cannot meet those obligations. Another characteristic feature of the general partnership is that each of its partners, unlike shareholders of corporations, has the authority to legally bind the partnership.
Partnerships will not automatically continue in existence following the death, bankruptcy, retirement or resignation of a partner. Moreover, because of their close legal ties, partners are given a right to choose their associates. Partners may also have the right to dissolve the partnership at will and withdraw their capital, thus declining to participate further in the risks and ventures of the partnership. In contrast, shareholders of a corporation must continue their investment unless the corporation is liquidated or purchasers for their stock can be found.
Another characteristic that distinguishes partnerships from corporations is the usual lack of free transferability of interests in the former. Specifically, partners can transfer their entire partnership interest — including status as a partner — only if all other partners consent. No such constraint exists with respect to the transfer of corporate stock.