When forming an alliance to reduce the financial risk of a new business venture, the tax implications of the business structure you choose for the venture should influence your decision. Because corporate taxation imposes double taxation, many entrepreneurs choose a partnership. However, you should also consider a limited liability company (LLC) because it has similar tax implications.
Forming the Alliance
Regardless of whether structure an alliance as an LLC or a partnership, the Internal Revenue Service will impose the partnership tax rules on all partners and members, provided you don’t make an election for corporate tax treatment when using an LLC. The partnership rules allow you to contribute cash and property to the venture without having to pay income tax on the value of the contribution, including the inherent gain in the property you transfer. Therefore, this allows all parties to fund the business without incurring taxes or having to file forms with the IRS.
Tax on Partners
If you use a partnership, the business isn't responsible for paying tax on its annual earnings. However, it has to file an annual tax return on Form 1065 for informational purposes only. Along with the 1065, the partnership must file a Schedule K-1 to reflect each partner's share of income, expenses, gains and losses. This is allocated based on the value of each partner's contribution to the alliance. When you receive the K-1, you must report the information on a Schedule E attachment to your tax return, and pay the appropriate amount of tax. The same tax consequences result regardless of whether you create a limited partnership, general partnership or limited liability partnership.
LLC Member Taxation
An LLC is commonly known as a hybrid-entity structure that has characteristics of partnerships and corporations. However, for federal income tax purposes only, the IRS disregards the LLC structure and automatically treats the LLC as a partnership if it has at least two members. As a result, the tax implications to the LLC and its members are identical to that of a partnership and its partners. The main distinction between an LLC and a partnership is that LLC members aren't as vulnerable to personal liability for the debts of the business as general partners of a partnership are.
LLC Corporate Election
In most cases, it’s not beneficial to use a corporate structure if your goal is to pay the least amount of income tax possible on the earnings from the joint venture. This is because the IRS always treats a corporation as a separate taxpayer from its shareholders, and as a result, the business pays corporate income taxes on its earnings before it distributes dividends to shareholders. When you receive a dividend, you must report it on your personal tax return and pay a separate income tax. However, when you choose an LLC structure, you can treat the business as a corporation for tax purposes instead of a partnership.
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