Entities Eligible for Partnership Taxation
A partnership is a business entity that requires at least two people to be conducting the business operations. The members of a partnership cannot be a corporation, trust, or an estate. For federal tax purposes, the partnership is treated as an aggregate of the partners. This phrase, “aggregate of the partners,” means that the income, gain, loss, or deductions of the partnership are allocated to the partners. The partners then report the items on their individual returns and they pay the corresponding taxes. Based on this principle, a partnership is described to be a “flow-through” entity. For other purposes, a partnership is treated as a distinct and separate entity. Based on this, a partnership is required to file their own tax return, 1065, and is subject to entity-level audit procedures. The majority of the tax elections that affect the partnership are made by the partners. The partners choose the partnership’s calendar tax year and their method of accounting. In addition, the partners are not treated as holding a direct interest in the assets of the partnership. In order for the partnership to avoid the separate entity principle, the partnership must elect out of the Subchapter K. Electing out of the Subchapter K allows the partners to remain partners of the partnership, but a partnership return does not have to be filed. Instead, each partner reports their share of the income on the return as a co-owner. However, there are certain requirements that must be met before a partnership is eligible to elect out of the Subchapter K.
To be eligible to elect out of Subchapter L, a partnership must be:
For investment purposes only and not for active business operation
For the joint production, extraction, or use of property
Dealers in securities for a short period of time for the purpose of underwriting, selling, or distributing a particular security
To make the election, the partnership will file a partnership return and attach a statement regarding why the partnership is eligible to opt out of the Subchapter K. Failure to follow the proper procedures for opting out of this election could hinder the partnership’s ability to avoid the Subchapter K. However, the facts and circumstances test could allow the partnership to still opt out. The fact and circumstances test requires that the organization must show that the members intended to opt out of the Subchapter K at the time of the organization’s formation.
By: Brooke Williams, Data Entry Specialist at CROFT & FROST