Updated December 2016
Jan Black, Partner. She’d dreamed of this day, and in January it happened. Years of study, hard work and dedication finally paid off. She was invited to be a partner in her firm.
Jan was prepared for the new responsibilities and the accompanying rewards. It meant she could finally buy that house, for one thing. And perhaps trade in her car for a newer model.
It turned out there was one thing, an important thing, that Jan wasn’t prepared for. A new set of tax rules that complicated her tax filings and dramatically impacted her cash flow and her federal and state tax liabilities.
If you’ve been promoted to partner in your firm, or soon will be, it’s vital to understand the financial and tax implications.
When you were an employee, your compensation was reported annually on Form W-2, and included a range of nontaxable benefits such as medical insurance, retirement contributions and parking or bus passes. Now, as a partner, your income and benefits will be reported each year on Schedule K-1, a part of your firm’s partnership tax return.
Your Schedule K-1 reports the portion of partnership income and deductions that is allocated to you. It may include multiple types of income and deductions if there are separately stated items on the partnership return that require different treatment at the partner level. Three of these separately stated items are ordinary income, guaranteed payments and distributions.
Ordinary income is your share of the partnership’s net income. It is taxable to you whether or not you’ve actually received the money.
Guaranteed payments are similar to a salary for your services. They are not determined based on the partnership’s income.
Distributions are withdrawals of cash and property from the partnership. They are generally not taxable.
The ordinary income and guaranteed payments you receive from the partnership are classified as self-employment income and are subject to self-employment taxes, in addition to income taxes.
Self-employment tax has two components: a Social Security tax (for 2016, 12.4 percent of your first $118,500 of self-employment income) and a Medicare tax (2.9 percent of all self-employment income). You can deduct half of your self-employment tax in calculating your adjusted gross income.
Your firm pays half of Social Security and Medicare taxes for employees, but not partners, which means your taxes as a partner are significantly higher. However, partners do get to deduct half of their self-employment taxes from gross income on their individual income tax returns, providing some relief.
The Affordable Care Act of 2010 added a 0.9 percent Medicare surtax for taxpayers with earned income, which includes self-employment income. It applies to earned income over $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers. This Medicare surtax is calculated separately from other self-employment taxes and none of it is deductible on your individual income tax return.
State and Local Tax Obligations
As an employee, your personal taxes weren’t affected by other offices your firm might maintain in Portland, Boise, San Francisco or any other state. As a partner, however, you may have additional state or local income tax filing obligations as a result of those out-of-state offices. This is because the partnership income, including your share, is apportioned among the jurisdictions in which your firm has offices and partners are considered to have earned their shares from all the offices, not just the office where you are primarily located.
State and local income tax filing requirements for nonresidents–including filing thresholds and tax return types–vary significantly by jurisdiction. Some jurisdictions require each partner to file a separate individual tax return. Others permit the partnership to file a composite return.
If your partnership files a composite return, it does so on behalf of all electing nonresident partners. It reports their portions of partnership income that are apportioned to the jurisdiction. The partnership also pays your share of the tax liability, so your portion of that liability may be withheld from partner distributions or treated as a guaranteed payment. If you are a resident of a state with an income tax, the composite tax paid by the firm on your behalf may be eligible for a credit against taxes owed in your state.
Estimated Tax Payments
As a general rule, you make estimated tax payments on income that is not subject to withholding. Your firm won’t withhold income or payroll taxes on your ordinary income or guaranteed payments so you’ll need to make your own federal and state quarterly estimated tax payments–taking into account self-employment tax and the additional Medicare surtax.
You can calculate your federal estimated payments based on your best estimate of the total income you expect to receive for the current year. To avoid an underpayment penalty, your estimated payments for the year must equal at least 90 percent of the current year’s tax liability.
Alternatively, you can use a safe harbor method to avoid the underpayment penalty without having to estimate your current-year income or tax liability. To use this method, each quarter you must pay an amount equal to one-fourth of your total tax liability for the prior year–or a total of 100 percent of last year’s tax liability. If your adjusted gross income exceeds $150,000, your estimated payments must be slightly higher, totaling 110 percent of the prior year’s tax liability.
State estimated tax payment requirements generally mimic federal rules, but you should review each state’s policy to ensure that you’re in compliance.
Now that you’re a partner, the tax treatment of various firm-provided benefits will likely change–many of them are no longer tax-free. This is because, for tax purposes, a partner is excluded from the definition of an employee with regard to certain fringe benefits. That makes those benefits taxable to the extent they’re paid for by your firm. Among the more common such benefits are health, life and disability insurance; transportation benefits; and retirement contributions.
The specific tax consequences for fringe benefits vary depending on the benefit and manner in which they’re paid.
If the cost of the benefit is paid by your firm, that cost is treated as a guaranteed payment which increases your taxable income. Alternatively, if your firm initially pays for the benefit but then withholds an equal amount from your distributions, you’re paying so the cost of the benefit is not a guaranteed payment and does not increase your taxable income.
In either case, you can deduct the amount on your individual income tax return to the extent allowed under the tax rules.
For example, while you must report the cost of health insurance premiums paid by your firm as income, you can take the full cost of your medical, dental and qualifying long term care insurance as a reduction to your adjusted gross income. Your insurance costs for yourself and your spouse, dependents, and non-dependent children under age 27 are eligible. There are certain limitations: The deduction only applies to insurance plans established by the partnership and it’s limited to the amount of income you received from the partnership for the tax year. Further, the deduction is not available for any period when you were covered by a subsidized insurance plan provided by an employer (other than the partnership) or your spouse’s employer.
Retirement Plan Contributions
The tax treatment of your retirement plan contributions is also different because you’re now considered self-employed. The specific tax treatment mirrors that described above for fringe benefits, in that it depends on how they’re paid.
In addition, your retirement plan contributions are deemed to be your expenses whether they are employee deferrals or employer contributions. As such, they are generally deductible on your tax return.
The maximum allowable contribution to your plan varies based on the type of plan and its funding requirements.
Application to Limited Liability Companies and S Corporations
The rules outlined above for partnerships also generally apply to a member of a limited liability company (LLC) or professional limited liability partnership (PLLP).
A shareholder who owns two percent or more of an S corporation is also subject to many of these rules, even though the shareholder will continue to be a salaried employee.
The transition from employee to partner can have a major impact on your personal tax situation. To avoid potential penalties and unexpected liabilities, be proactive and seek the advice of an experienced tax consultant who can help you apply the new set of tax rules. If you’re an S corporation shareholder, your tax consultant can also provide more information regarding the application of benefits rules to your situation.