Different Entities Mean Different Equity – Distributing Partnership Proﬁts and Losses
Since partnerships don’t pay their own income taxes, being pass-through entities (structures where only the owners pay taxes on the business income, which you’ll learn more about in Chapter 16), any proﬁts or losses have to be divided among the partners. The partners then include their shares of those proﬁts or losses on their personal income tax returns. Each partner’s portion is called a distributive share, and it’s 100 percent taxable even if the partner doesn’t get any actual money. In other words, as a partner you have to pay income taxes on your share of proﬁts even if you don’t withdraw a dime, and even if no cash is available for you to withdraw.
The phenomenon that occurs when a partner has taxable income from the company but doesn’t receive any money is called “phantom profits.” That’s because the actual profits to the partner are invisible, except for their tax effect. This can occur because of a decision among the partners to leave all the cash in the business to finance growth, or because there’s just not enough cash to go around.
In most cases, distributions are based on how much equity each partner has in the company now, or when the company was ﬁrst started. How- ever, if you and your partners want to divide earnings in some other way, you can. Many small partnerships don’t like to use ﬁxed distribution percentages, carved in stone, because equity shares can change over the life of the partnership depending on individual contributions and withdrawals.
The Most Flexibility
Partnerships offer the most ﬂexibility when it comes to splitting up prof- its and losses for businesses that have more than one owner. Unlike corporations, in which earnings have to be divided based on each owner’s respective equity percentage, partnerships allow owners to ﬁgure the split however they want as long as they all agree to it in writing. So, for example, a partner who has a 50 percent equity stake in the business could get 25 per- cent of the proﬁts and 60 percent of the losses.
If you and your partners do choose to divide proﬁts and losses in any proportion that’s different from your equity shares, you have to put that decision in writing, and all of you have to sign off on it. This is usually incorporated into the partnership agreement.
Good Reasons for Uneven Splits
While it’s perfectly legal to split proﬁts and losses however you and your partners want to, there has to be some reasonable basis for the numbers you come up with (at least a reason that will satisfy the IRS if it starts asking questions). Good reasons include things such as one partner working more hours for the company, which means she deserves a bigger share of proﬁts or losses; or one partner bringing in more new clients than any of the others.
While technically you aren’t required to have a partnership agreement to have a partnership, it’s in the best interest of you and your partners to take the time to draw one up. It will cost you some money up front (definitely have a lawyer do this), but it will save you a lot of money and heartache down the line.
Although the IRS may look at uneven proﬁt distributions, it’s usually more interested in uneven loss distributions. That’s because partner- ships are pass-through entities, and losses sustained by the partnership are directly deductible from other forms of income on the partners’ personal tax returns. Make sure that you and your partners have a solid explanation for any seemingly uneven distributions, especially if one partner gets a dis- proportionate share of losses only.