Do partnership distributions have to be equal? Partner equity does not typically equate to equivalent investment contributions from all business partners.3 min read
Updated July 8, 2020:
Do partnership distributions have to be equal? Partner equity does not typically equate to equivalent investment contributions from all business partners. Instead, partners can make equal contributions to the company and possess equal ownership rights, but make contributions in a variety of different forms.
What Are the Three Common Ways to Take Money out of a Partnership?
There are three standard ways to take funds out of a partnership:
- Return of capital: Refers to principal payments back to the partners that exceed the growth of a business or investment.
- Distribution of income: The process of sharing the net income of a partnership between the partners in a proportion that aligns with the partnership agreement.
- Loan to partner: Refers to the process of borrowing money from the capital of the partnership.
What Are the Allocation Methods Used to Distribute Partnership Income?
In order to distribute partnership income, there are a number of ways to allocate the funds. These include:
- Specified ratios,
- Partners' service contributions,
- Partners' relative capital investments.
A combination of all of the different allocation methods can also be used.
What Is the Most Common Allocation Method?
The most common way partners allocate net income is through the relative capital investment of each individual. To clarify, if partner A and B each supply 50 percent of the capital then each person will receive 50 percent of the company's net income.
Is Unequal Distribution of Profits Allowed?
A partnership agreement may specify that unequal profit percentage is available to a partner and isn't dependent on the amount of his/her capital distribution. For example, if partner A and partner B both make initial capital contributions of 50 percent each, a partnership agreement can document the understanding that partner A receives 40 percent of the net profit while partner B receives 60 percent.
What Should Be Set up to Record Loans to Partners From the Partnership?
Borrowing from a partnership is allowed. This is completed by setting up a notes receivable account in order to record any loans that a partner takes from the partnership. The borrowing partner should prepare and sign a promissory note. The note should contain specific items regarding the loan, such as:
- The principal (the amount financed),
- Repayment date(s),
- Interest rates,
- Late payment penalties,
- Installment payment amounts.
Another option when taking money out of a partnership is to reclaim all or part of the initial capital investment.
Is a Return of Your Capital Taxable?
Returned capital is also not taxable. It is important to note that if you do decide to liquidate the partnership and receive an amount that is more than your capital investment, the excess is considered capital gain. It is considered a capital loss if you receive less than your initial investment.
Tax on Retained Earnings in a Partnership
In a partnership, the income passes through to the partners. This means that a partnership does not pay taxes, but rather the partners do. In fact, it is the responsibility of the partners to ensure that they pay tax on their income. Remember that what the Internal Revenue Service (IRS) considers income and what the members of a partnership declare as income may be widely different, especially when it comes to retained earnings. This refers to funds that have been generated by the business, but not taken out from the partners.
Retained Earnings as Income
When members leave profits in the partnership rather than withdrawing them, this is referred to as retained income. The IRS states that partners must pay taxes on this generated income because it is considered as distributed funds. Leaving retained profits in the business doesn't exempt the funds from being taxed. This is because partnerships do not get taxed, but the partners do. All retained earnings should be filed on each partner's Form 1040, which is one of three different IRS forms utilized for filing individual federal income tax returns.
Filing Form K-1 and Form 1065
There are specific forms that a partnership must complete when filing taxes. For example, a partnership must file a Schedule K-1 with the IRS and provide a copy to each partner. The Schedule K-1 Form reports each member's share of the losses and profits. These figures must correlate to members' claims on their personal income tax forms. The IRS will also require the partnership to complete Form 1065 to determine if all the partners are appropriately reporting their income.
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Now, let's delve into the key concepts covered in the provided article:
Partner Equity and Investment Contributions:
The article emphasizes that partner equity doesn't necessarily correlate with equal investment contributions. Partners can have equal ownership rights while contributing in various forms. This flexibility allows partners to contribute to the company in ways beyond monetary investments.
Ways to Take Money out of a Partnership:
The article outlines three standard methods:
- Return of Capital: Principally paying partners back more than the growth of the business.
- Distribution of Income: Sharing net income in alignment with the partnership agreement.
- Loan to Partner: Borrowing money from the partnership's capital.
Allocation Methods for Distributing Partnership Income:
Various methods exist, including specified ratios, partners' service contributions, and partners' relative capital investments. A combination of these methods can also be employed.
Most Common Allocation Method:
The article asserts that the most common way to allocate net income is based on the relative capital investment of each partner. If partners A and B each contribute 50 percent of the capital, they would typically receive 50 percent of the company's net income.
Unequal Distribution of Profits:
The partnership agreement can specify unequal profit percentages, decoupled from the capital distribution. For instance, if both partners contribute 50 percent initially, the agreement might dictate that partner A receives 40 percent of the net profit while partner B receives 60 percent.
Recording Loans to Partners:
Borrowing from a partnership involves setting up a notes receivable account and preparing a promissory note. The note should detail the principal, repayment dates, interest rates, late payment penalties, and installment payment amounts.
Tax Implications:
Returned capital is not taxable, but if a partner receives more than their capital investment during liquidation, the excess is considered capital gain. Conversely, receiving less than the initial investment results in a capital loss.
Tax on Retained Earnings:
Partnerships themselves do not pay taxes; rather, the responsibility falls on individual partners. Retained earnings, left within the business, are considered distributed funds and are taxable. Partners need to report retained earnings on their individual tax forms.
Filing Requirements:
Partnerships must complete Schedule K-1 and Form 1065 for tax filing. Schedule K-1 reports each member's share of losses and profits, while Form 1065 helps the IRS ensure partners are appropriately reporting their income.
In conclusion, understanding the nuances of partnership distributions is crucial for partners to navigate financial matters, tax implications, and legal requirements effectively. For specific legal advice related to partnership distributions, individuals can seek assistance from qualified lawyers on platforms like UpCounsel.
