Most entrepreneurs begin their partnerships with the intention of their businesses lasting for many years, if not a lifetime. However, not all partnerships mature into successful business ventures. This can be due to various factors—often beyond the partners’ control—such as lack of access to sufficient capital or absence of a market for the partners’ product. In these cases, partnership termination may be the best course of action. Partnership termination is the process of dissolving the partnership and allowing each member of the business to go their own way.
In other cases, dissolving a partnership may be required where a partner dies, withdraws, retires, or is expelled from the partnership. In each case, the tax consequences of dissolving a business partnership may differ. In this post, the BrewerLong team will help business partners understand how partnership termination tax consequences may affect your business in the event of a dissolution.
Partnership Termination Tax Consequences
A partnership is a pass-through tax entity, which is why many entrepreneurs select this type of business when setting up their company. While a partnership can own fixed assets and have employees, it does not pay income taxes. Instead, income taxes are “passed through” to partners’ individual income tax returns. Despite not having to file an income tax return or pay income taxes, partnerships must file annual information returns with the Internal Revenue Service (IRS) using Form 1065: Return of Partnership Income. The information provided in these returns plays an important role in determining the tax effects of a liquidation of a partnership.
The term “basis” may sound like a complex tax term, but it simply means the total investment that a business partner has put into the partnership firm. When a partnership is terminated, each partner must pay taxes on the positive difference between the money distributed to a partner at the termination of the partnership and their basis in the partnership interest just prior to the termination.
It is important to note that the tax consequences of dissolving a partnership can be slightly different depending on how the assets of the partnership are distributed. If the partnership is liquidated into cash, the partner will likely need to pay tax on cash received immediately. For the liquidated distribution of fixed assets, like property that will need to be sold and converted into cash, taxes will likely not need to be paid until the property is sold.
What Happens If a Partner Has a Negative Partnership Account?
If your partnership has multiple partners, each partner should have a separate capital account to track their basis. Usually, partners are allocated partnership gains and losses in proportion to how much they contributed to the partnership. A capital account becomes negative when the partnership allocates tax losses or deductions to partners in excess of their contributions or tax basis in the partnership.
If a partnership is liquidated where a partner has a negative capital account, the partner with the negative capital account is expected to pay back the amount owed to the partnership within 90 days of the partnership termination or by the end of the year, whichever comes first. Despite having a negative account, the partner still receives final distributions based on their original basis and can use these to clear their debt to the partnership. A partner with a negative capital account is liable to pay taxes only if the liquidated distributions result in taxable income.
Are the Partnership Termination Tax Consequences Different If I Have Employees?
If your partnership has employees, your tax consequences are not necessarily different, but you may have a few extra steps to complete. As you dissolve, you must make final payroll tax deposits and report employment taxes to the IRS using the applicable quarterly or annual payroll tax return forms and Form 940.
Employers are also required to provide employees and the IRS with their final wage reports using Form W2. You will also have to provide any contractors with final tax information. If your business paid more than $600 to contractors, you must provide them with Form 1099-NEC.
How Long Should I Keep Records After I Dissolve My Partnership?
The length of time you will need to keep your business records depends upon several factors. These factors include:
- The business action mentioned in the document,
- Any business expense recorded, and
- The event recorded in the document.
Businesses should keep property records until they dispose of the property in a taxable disposition. Business owners should keep all records of employment taxes for at least four years.
How BrewerLong Can Help
BrewerLong is here to help with the full lifecycle of your Florida partnership. We are a relationship-focused law firm that can give your business the personalized attention it deserves. Contact BrewerLong today, and we can handle the law so you can focus on business.
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