Generally, income from a partnership is allocated according to the partnership agreement and treated as personal income by the partners. It is taxed at the rate of each partners’ personal income level. Partners are required to report and pay income tax on this money even if it is left in the business, either voluntarily or as part of the partnership agreement.
After profits are allocated, the partnership files an informational tax return with the IRS which reflects the income it earned and how that income was allocated among the partners. The partners are then required to report the income on their personal tax returns. Any legitimate business expenses can be deducted from the profits before it is distributed.
Also, the partners are personally responsible for self-employment taxes, to cover Medicare and social security taxes. In most cases, the partners are required to make estimated payments each quarter for these taxes.
Typically, for tax purposes a LLC is treated like a sole proprietorship if there is one member or a partnership if there are multiple members. The LLC members are required to pay taxes on the income as personal income and pay self-employment taxes, just like a partnership. However, any members that are not a part of management decisions but only receive profits as part of ownership shares may be exempt from the self-employment taxes.
The only difference for tax purposes is that LLCs can choose to be taxed like a C corporation. This means that the LLC would pay taxes itself at the corporate tax rate before the money is distributed. The LLC will be taxed in this manner for a minimum of five years if it chooses this route, and there may be other tax consequences as well.
A partnership or LLC might be better served by incorporating, since a corporation can earn its own income and pay its own income taxes before profits are distributed. Money distributed to corporation owners is then taxed as dividends instead of income. Any money earned as an employee of the corporation, however, is treated as income. Given the difference between the corporate and individual tax rate, this may be beneficial to the owners.
The tax laws of different types of businesses can be very complex. An experienced business attorney can advise you of the advantages of each business setup and help determine which is best for you. An attorney can also help with the complex process of setting up a partnership, LLC, or corporation.