There are a few important tax disadvantages and complications that partnerships should consider. A prospective new partner should understand these concerns before joining the business.
Exposure to SE tax. Your new partner may owe self-employment (SE) tax — consisting of the 12.4% Social Security tax component and the 2.9% Medicare tax component — on some or all the income passed through to him or her by the partnership. (The partner will be able to deduct the “employer” portion of these taxes — 6.2% and 1.45%, respectively — from his or her SE income.) At higher income levels, the new partner may also owe the 0.9% additional Medicare tax.
In contrast, if you run your business as an S or C corporation, the partners will owe the “employee” portion of Social Security and Medicare taxes (6.2% and 1.45%, respectively, in the form of the FICA tax) plus, if applicable, the 0.9% additional Medicare tax only on amounts paid out as salary to them.
Important: Limited partners owe SE tax only on guaranteed payments received for services rendered to the partnership. General partners don’t qualify for this break.
Complicated Section 704(c) tax allocation rules. If the partners, including your incoming partner, simply contribute cash to acquire their partnership interests, then making federal income tax allocations is fairly straightforward. But if a partner contributes assets with fair market values that differ from the assets’ tax basis, Sec. 704(c) allocation rules come into play. Long story short, these rules require the partnership to make tax allocations that factor in the difference between the tax basis and the fair market value of contributed assets.
For example, let’s say your new partner contributes raw land worth $1 million with a tax basis of only $250,000. If the land is later sold by the partnership for more than $250,000, the first $750,000 of taxable gain must be allocated to the new partner under the Sec. 704(c) rules. These rules may also come into play in more complicated ways, such as allocating depreciation deductions for contributed depreciable assets. Ask your tax advisor for more details if partners contribute noncash assets.
Disguised sale rules. The partnership disguised sale rules are one of the most complicated subjects in partnership taxation. These unfavorable rules can cause what appear to be nontaxable transfers of assets between partners and partnerships to be treated as partially or wholly taxable sales.
For example, let’s say your incoming partner contributes appreciated property to the partnership and then receives a cash distribution from the partnership. Under the disguised sale rules, this can potentially be treated as a wholly or partially taxable sale of the appreciated property to the partnership, depending on the size of the distribution and how closely it occurs in time to the property contribution. If disguised sale treatment applies, your new partner could face an unexpected tax liability.
Consult your tax advisor before finalizing significant partner or partnership transactions, including transactions with an incoming partner. Proactive planning can often prevent unexpected and adverse tax outcomes under the disguised sale rules.