Many small businesses need to attract capital from wealthy individual investors or pension funds to get started. The vehicles of choice for these investments have historically been partnerships or limited liability companies (LLCs), which are generally taxed in the same manner as partnerships. While there are many reasons why partnerships and LLCs are used for this purpose, some of the more significant reasons are discussed herein. Unless otherwise noted, references to partnerships in this article are intended to include LLCs.

First, a partnership passes through its taxable income (or loss) to its investors, thereby avoiding double taxation and allowing the partnership the option to retain working capital for growth. Entity level, or "double," taxation is a major reason why C Corporations are not typically used to raise capital. Second, there are no restrictions on the number or types of partners who can be in a partnership. In contrast, an S Corporation, which also passes through its income to its shareholders, can have no more than 100 owners (all of whom must be U.S. citizens), cannot have corporate shareholders, and can only have one class of stock. Third, a partnership can provide for preferential return of capital and profit distributions and for special allocation of tax losses, which is not possible with an S Corporation due to its one class of stock limitation.

Preferred return of capital and profits and special allocation of tax losses to certain owners are the principal reasons why partnerships are used for raising capital in small businesses, and particularly real estate investments. A common structure is for the entrepreneur to seek out investors, or "money partners," to contribute the bulk of the capital, and in return the money partners will receive a preferred return on their investment (a stated annual return on their money similar to interest on a loan) plus a return of their original investment. After these amounts are paid, the remaining cash to distribute over the lifetime of the investment is split in some ratio with the entrepreneur. The ratio is often the product of negotiation and influenced by the entrepreneur's track record in previous investments. For the entrepreneur, the possibility of receiving future distributions that often are far in excess of his own capital investment provides strong incentive for him to acquire, develop and operate the investment in as efficient a manner as possible.

Often the first years of an investment, especially a real estate investment with large depreciation deductions, generate substantial tax losses even though cash flow may be positive. Allocation of these tax losses to the money partners can significantly increase the internal rate of return on their investment by providing them with an immediate income tax benefit (subject to the passive loss rules). In addition, certain investments, particularly debt financed real estate investments with “qualified non-recourse financing,” permit investors to claim tax losses far in excess of their original investment. This, too, is only possible by using a partnership structure. Note that the ability to deduct losses in excess of invested capital provides a temporary, not a permanent tax deferral. The tax deferral can be for many years, however, and some of the losses originally claimed at ordinary tax rates may be recaptured in later years at lower capital gains tax rates.

While partnerships provide many advantages for raising capital, some pitfalls need to be considered. First, although the flow through aspect of partnership income taxation has its advantages, it can also cause some headaches. The partner's income tax return is directly impacted by the partnership's tax return and cannot be filed until he receives his Schedule K-1 from the partnership. This means that the partnership K-1 will have to be finished well before the April 15 filing deadline if the partner wants to file his tax return without requesting an extension of time to file. Typically this is not a problem; however, if, for example, the partnership has its own outside investments that are late in reporting, the partnership's tax returns and corresponding K-1s may be completed late. For a partner who has always filed timely, having to file for an extension to file his tax return may be disconcerting.

Second, most states require that the partnership withhold taxes from distributions to non-resident partners and remit those taxes to the state. The withholding rate often exceeds the partner's true tax liability in the state and requires him to file a tax return in that state to recoup the excess tax withheld.

Third, many partnerships conduct business in multiple states that require the partnership and partners to file non-resident tax returns in those states. As states search for more revenue, they are more aggressively pursuing out-of-state businesses doing business in their states. This creates additional compliance costs for both the partnership and its partners and can be particularly burdensome to partners not experienced with multi-state filings.

Fortunately, a composite state filing by the partnership can alleviate some of these pitfalls. A composite filing is available in most states and relieves the partners from having to file individually. The partnership instead files one return in that state on behalf of all electing partners (a partner generally can elect out of a composite filing) and pays the tax on the partners' behalf (the tax paid is deemed a distribution to the partner). A composite filing generally is only available to individuals, trusts and other partnerships — not corporate partners — and a partner cannot have any other source of income in the non-resident state to participate in a composite filing. The tax the partnership pays with a composite return is generally a flat tax at the highest rate, so individual partners occasionally may pay more in tax by participating in a composite return. The relief from having to file several non-resident state tax returns, however, may be worth the additional tax. Each state has different composite return filing requirements which must be navigated but, nevertheless, composite returns often provide a practical solution to the cumbersome multi-state filing rules.

As the economy gradually improves, the use of partnerships to raise capital by new entrepreneurs can be expected to increase. It is important to understand the advantages and pitfalls of operating in a partnership. Your CBIZ MHM tax advisor is available to help you make the best decision for your particular situation.

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