How to Form a Partnership: Agreements, EINs, Tax Returns, and Compliance

A general partnership is the one business structure that can spring into existence whether you mean it to or not. The moment two or more people go into business together to share profits, you have a partnership in the eyes of most state law, even with nothing in writing. That is the part people miss. You do not file a document to create a basic general partnership the way you do with a corporation or an LLC. The law treats your handshake as the formation event. The real work is making that default arrangement say what you actually want it to say, because the version the law writes for you by default is rarely the version you would choose.

The first concrete step is a written partnership agreement. This is the document that overrides the bare default rules your state would otherwise impose. It should spell out each partner’s capital contribution, the percentage each partner owns, how profits and losses get split, who has authority to sign contracts and spend money, what happens when a partner wants out, and how the business gets valued if someone dies or leaves. Without this, a state statute decides those questions for you, and the statutory default often splits everything equally regardless of who put in the money or did the work. Two partners who each contributed wildly different amounts of cash can end up with a fifty-fifty split they never intended, simply because they never wrote down anything different.

The second step is getting an Employer Identification Number from the IRS. Every partnership needs its own EIN even if it never hires a single employee, because the partnership files its own tax return and the EIN is how the IRS tracks that entity separate from the partners as individuals. You apply with Form SS-4, and the fastest route is the online application on the IRS website, which issues the number on the spot during business hours. The SS-4 instructions walk through the line items, including the entity type, the reason you are applying, and the date the business started. Do not skip this and run partnership income through one partner’s Social Security number. That creates a reporting tangle that takes real effort to unwind later.

Third comes state and local registration. This part varies a great deal by where you operate. Many states want a partnership operating under a name other than the partners’ own surnames to file a fictitious name or doing-business-as registration with the county or state. If you sell taxable goods or services, you likely need a state sales tax permit. Some cities require a general business license on top of that. If the partnership will hire workers, you also register for state unemployment insurance and state withholding accounts. None of these is hard on its own, but the list adds up, and missing one often surfaces only when a notice arrives months later.

Fourth, set up the financial backbone before the money starts moving. Open a bank account in the partnership’s name using the EIN, and keep partner money and business money strictly apart. Commingled funds are one of the most common bookkeeping messes we untangle, and clean separation from day one prevents most of it. Our bookkeeping work is built around getting the ledger right from the start so the year-end return is a summary of clean records rather than a reconstruction project.

Once the partnership is running, the tax side begins. The entity files Form 1065 each year as an information return, and it issues a Schedule K-1 to each partner reporting that partner’s share of income and deductions. Those two forms are the heart of partnership tax reporting, and they are why getting the agreement and the books right early matters so much. We handle entity setup decisions and the planning that surrounds them through our tax strategy consulting service, so the structure you form on day one is the one that actually fits how you plan to operate and eventually exit.

A partnership does not pay federal income tax itself. That single fact drives almost everything about how partnership taxation works. The partnership is a pass-through entity, which means the income, deductions, gains, and losses flow through the business and land on the individual returns of the partners, who pay the tax at their own rates. The business files a return, but that return is informational. It reports what the partnership earned and then divides those numbers among the partners according to the partnership agreement. The tax bill shows up on the partners’ personal returns, not on the partnership.

The return the partnership files is Form 1065, the U.S. Return of Partnership Income. It reports total revenue, the ordinary business expenses, and the resulting ordinary business income or loss, along with separately stated items like interest income, capital gains, and certain deductions that have to keep their character as they pass to the partners. The Form 1065 instructions lay out what belongs on the face of the return versus what gets broken out separately. The filing deadline is March 15 for a calendar-year partnership, a full month before the individual deadline, and that timing is deliberate. The partnership has to finish first so the partners have the figures they need for their own returns.

Each partner receives a Schedule K-1, which is the document that carries that partner’s slice of every line item from the 1065 onto the partner’s personal return. Box 1 of the K-1 reports ordinary business income or loss. Other boxes carry interest, dividends, capital gains, section 179 deductions, guaranteed payments, and a long list of other items, each in its assigned box so it lands in the right place on the partner’s return. The Schedule K-1 instructions map each box to where it goes. A partner who is an individual reports the ordinary business income from K-1 Box 1 on Schedule E of the Form 1040, which is the schedule for income from partnerships, S corporations, rentals, and trusts.

Here is the part that surprises new partners every year. You owe tax on your share of the partnership’s income whether or not the partnership actually distributed cash to you. The K-1 reports your allocated share of profit, and that allocation is taxable even if every dollar stayed in the business to fund growth. People expect to be taxed on what they took out. The rule taxes them on what they earned. A partner with a thirty percent stake in a business that made one hundred thousand dollars reports thirty thousand dollars of income, full stop, even if the partnership reinvested all of it and wrote no checks to the partners.

Self-employment tax is the second thing that catches people. A general partner’s share of ordinary business income is generally subject to self-employment tax, which covers Social Security and Medicare. This is not withheld for you the way it is for an employee. You compute it on Schedule SE and pay it with your individual return. The K-1 reports your self-employment earnings in Box 14 with code A, and that figure feeds the Schedule SE calculation. For active general partners this adds roughly fifteen percent on top of the income tax for the portion of earnings below the annual Social Security wage base, which is real money that a lot of first-year partners forget to set aside.

Because nothing is withheld, partners generally have to make quarterly estimated tax payments to cover both income tax and self-employment tax. Wait until April and you face an underpayment penalty even if you pay the full balance then. We see this trip up new partners constantly, and it is one of the first things we set right. We prepare the partner-level returns through our individual tax return preparation service and build the quarterly estimate plan alongside the entity work through our tax strategy consulting service, so the K-1 that arrives in spring is never a shock.

These three sit under the same federal tax umbrella but differ sharply in who is on the hook when something goes wrong. All three are generally taxed as partnerships, meaning each files Form 1065 and issues a Schedule K-1 to each owner. The tax mechanics are the same across all three. What separates them is legal liability and the role each owner plays in the business. Choosing among them is mostly a question of how much personal risk you are willing to carry, not how the income gets taxed.

A general partnership is the plain default. Every partner is a general partner, which means every partner has unlimited personal liability for the debts and obligations of the business. If the partnership is sued or cannot pay its creditors, the partners’ personal assets are exposed, and it gets worse than most people expect. Under joint and several liability, one partner can be made to pay the full amount of a partnership debt even if another partner caused the problem. That partner’s only recourse is to chase the others for their share. A general partnership is the cheapest to form because it can exist with nothing filed, but that low cost comes with the highest personal exposure of the three.

A limited partnership splits the owners into two classes. It has at least one general partner who runs the business and carries unlimited personal liability, and one or more limited partners whose liability is capped at what they invested. The tradeoff for that protection is that limited partners are generally passive. They put in money but cannot take an active hand in running the business without risking their limited status and the liability shield that comes with it. This structure shows up a lot in investment and real estate deals, where the people putting up capital want exposure limited to their check and are happy to let a managing general partner handle operations. For tax purposes a limited partner’s income is often not subject to self-employment tax, while the general partner’s share generally is, which is one place the two classes diverge on the partner-level return reported on Schedule E.

An LLC taxed as a partnership is, for most small businesses with more than one owner, the structure that makes the most sense. A multi-member limited liability company defaults to partnership taxation, so it files the same Form 1065 and issues the same K-1s, but it gives every owner the liability protection that a general partnership denies and a limited partnership grants only to its passive class. In an LLC, all the members can actively run the business and still keep their personal assets shielded from business creditors. You get the pass-through tax treatment of a partnership and the liability wall of a corporation in one entity, which is why it has become the default choice for so many partnerships that want protection without corporate formality.

The self-employment tax picture for LLC members is less settled than people assume. Members who actively work in the business generally pay self-employment tax on their share of ordinary income, computed on Schedule SE, much like a general partner. Whether a more passive LLC member can treat some income as exempt from self-employment tax is an area where the rules are genuinely unsettled, and aggressive positions there draw IRS attention. This is not a place to guess. It depends on the member’s actual role and how the operating agreement reads.

Picking among the three is a legal and tax decision rolled together, and the right answer depends on your liability tolerance, who needs to actively manage, and where you operate, since state rules and state-level entity taxes differ. We work through that choice with clients through our tax strategy consulting service before anything gets formed, and then prepare the resulting partner returns through our individual tax return preparation service so the entity choice and the filings line up.

Basis is the single most misunderstood concept in partnership taxation, and it is the one that quietly decides whether you actually get to deduct a loss your Schedule K-1 hands you. Your outside basis is your tax investment in the partnership interest. Think of it as the running total of what you have put in and earned, reduced by what you have taken out and your share of losses. The formula is workable once you see it laid out. Basis equals your capital contributions, plus your share of partnership income, plus your share of partnership liabilities, minus distributions you received, minus your share of partnership losses. It moves every year, and you have to track it.

The starting point is what you contribute. Put in fifty thousand dollars of cash, and your basis starts at fifty thousand. Contribute property instead of cash, and your basis generally carries over from your basis in that property rather than its market value, which is a distinction that trips up partners who assume they get credit for what the property is worth today. From that starting figure, basis climbs each year by your allocated share of the partnership’s income reported on the K-1, because that income is already being taxed to you, so the tax system credits it to your investment. It also climbs when the partnership takes on debt that you share, since partners get basis for their portion of partnership liabilities, a feature that sets partnerships apart from S corporations.

Basis falls in two main ways. Distributions reduce it, because taking cash out is recovering part of your investment. Allocated losses reduce it too, because a deducted loss is a return of capital in tax terms. The order matters, and so does the floor. Basis cannot go below zero. That floor is the whole reason basis controls your loss deductions, and it is where the rule bites hardest on partners who funded the business lightly but absorbed a big share of early losses.

The loss limitation rule is direct. You can deduct partnership losses on your individual return only to the extent of your basis. If your K-1 reports a forty thousand dollar loss but your basis is only twenty-five thousand, you deduct twenty-five thousand this year and the remaining fifteen thousand is suspended. It does not vanish. It carries forward and becomes deductible in a future year when your basis goes back up, whether from contributing more money, the business turning profitable, or taking on more partnership debt. The loss waits for basis to support it. A partner who deducts the full loss without checking basis is taking a deduction the law does not allow, and that is exactly the kind of position that does not survive examination.

The capital account is related but not the same thing, and conflating the two causes endless confusion. Your capital account tracks your equity in the partnership for book and partnership-agreement purposes, and it appears on your K-1 in the section that reconciles your beginning balance, contributions, share of income, distributions, and ending balance. Outside basis is a tax figure that includes your share of partnership debt. The capital account does not include that debt. So the two numbers routinely differ, and you cannot read your deductible loss off the capital account. You have to track basis separately, because the capital account on the K-1 will mislead you on the one question that matters most for losses.

The deductible loss eventually flows to Schedule E on your Form 1065-driven personal return, but only after it clears the basis test, and then at-risk and passive activity rules can limit it further. Tracking basis year after year is tedious and easy to neglect until the year a loss shows up and the number suddenly decides your deduction. We maintain partner basis schedules as part of our bookkeeping work and fold the loss limitation analysis into the planning we do through our tax strategy consulting service, so a loss on your K-1 is a loss you can actually use.

The reason a profitable partnership looks at an S corporation election comes down to one tax. Self-employment tax. A general partner pays self-employment tax on the full share of ordinary business income, computed on Schedule SE, which runs about fifteen percent on earnings below the annual Social Security wage base and continues at the Medicare rate above it. On a healthy profit, that tax adds up fast. An S corporation changes the math, because an owner who works in the business is paid a salary as an employee, and only that salary carries Social Security and Medicare tax. Profit distributed beyond the salary is not subject to self-employment tax. That gap is the entire appeal.

An example makes it concrete. Say a partner is netting one hundred fifty thousand dollars of ordinary income from the business. As a partner, the whole one hundred fifty thousand runs through self-employment tax. Convert to an S corporation, pay yourself a reasonable salary of, say, eighty thousand dollars, and only that eighty thousand bears payroll tax. The remaining seventy thousand passes through as a distribution free of self-employment tax. The savings on that spread can run into five figures a year. That is the headline number that gets owners interested, and on paper it looks like an easy win.

The catch is the words reasonable salary, and the IRS means them. You cannot pay yourself a token wage and route everything else as a distribution to dodge payroll tax. The salary has to reflect what the work you do is actually worth in the market. Pay an unreasonably low salary and the IRS can reclassify your distributions as wages, then pile on back payroll taxes, penalties, and interest. This is one of the most heavily examined positions in small business tax. The reasonable-salary requirement is the tradeoff that makes the strategy work only above a certain profit level. Below that level, the payroll cost and the compliance burden eat the savings.

The mechanics of making the election depend on what you are converting. A partnership or multi-member LLC first elects to be treated as a corporation by filing Form 8832, the entity classification election, and then files Form 2553 to elect S corporation status. The Form 8832 instructions cover the classification mechanics and the effective-date rules. Timing is strict. To have the S election apply for the current tax year, Form 2553 generally must be filed within two months and fifteen days after the start of that year, which for a calendar-year business means by March 15. Miss it and the election usually takes effect the following year, though relief for a late election is available in some circumstances if you have a reasonable cause. An entity already organized as a corporation skips Form 8832 and files Form 2553 alone.

Once the S election is in place, the entity stops filing Form 1065 and instead files Form 1120-S, the income tax return for an S corporation. It still issues K-1s to the owners, but they are S corporation K-1s rather than partnership K-1s, and the owner’s share of income reported there is generally not subject to self-employment tax. The Form 1120-S instructions lay out the filing requirements, which include running real payroll for the owner-employees, filing quarterly payroll returns, and issuing yourself a W-2. That payroll obligation is the hidden cost. It is why an S election rarely pays off until profit is high enough that the self-employment tax savings clear the cost of running payroll and the extra return.

An S corporation is not right for every business, and the breakeven depends on your profit, a defensible salary figure, your state’s treatment of S corporations, and how you plan to take money out. We run that breakeven analysis before recommending an election through our tax strategy consulting service, then handle the payroll setup and the changed filings through our individual tax return preparation service so the move actually saves what it promised on paper.