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A partnership is an unincorporated business with two or more owners. For businesses with more than one owner, the IRS will presume that your business should be taxed as a partnership unless you have incorporated under state law, or you elect to be taxed as a corporation by filing IRS Form 8832, Entity Classification Election.
A partnership is not a taxable entity under federal law there is no separate partnership income tax, as there is a corporate income tax. Instead, income from the partnership is taxed to the individual partners, at their own individual tax rates.
However, the partnership is required to file a tax return (Form 1065) that reports its income and loss to the IRS, and also reports each partner's share of income and loss on Schedule K-1 of the 1065. For tax purposes, all of the income of the partnership must be reported as distributed to the partners, and they will be taxed on it through their individual returns. This is true whether or not the partners actually received their shares of the income, and even if the partnership agreement requires that the money be retained in the business as partnership capital.
Partnerships are generally the most flexible form of business for tax purposes, since the income and losses distributed to each of the partners can vary (e.g., one partner can receive 40 percent of any profits but 60 percent of any losses), as long as a business purpose other than tax avoidance can be shown for the split. In the early years of most businesses, the company generates losses rather than profits, and the partnership form allows the partners to use these losses to offset other income they may have from investments or another job. One caveat is that the partners may not deduct losses that exceed the amount of their investment in the business. But any losses that can't be deducted as a result of this rule can be deducted in subsequent years if the partner increases his or her investment.
Although the individual partners (not the partnership) are the ones paying the income tax, most of the choices affecting how income is computed must be made by the partnership, rather than the individual partners on their own returns. These choices include elections of general methods of accounting, methods of depreciation, and accounting for specific items, such as organization and business startup expenses and installment sales. Partners are required to treat partnership items in the same way on their individual tax returns as they were treated on the partnership return.
There are a number of nontax factors that may influence the decision as to whether a partnership is the right form of business for you, and we recommend that you seek legal advice in setting up a partnership and writing up the partnership agreement.