By: Joseph Moukhliss, EA
It’s often the goal of a professional to become a partner at a firm. Competitive business environments lead companies to offer employees equity partnership or shareholder status to reward and retain top talent. After years of hard work, loyalty and driving revenue, partnership is a worthy reward. Many new partners, however, are unaware of how their new role will impact their tax situation. Today’s blog highlights some of the major changes a professional will encounter when transitioning from an employee to a partner and provides some tips on preparing for those changes.
One of the major changes in becoming a partner is that as an owner, the partner will receive a Schedule K-1 for income tax purposes rather than a W-2. The Schedule K-1 reports the partner’s share of the company’s income, loss, deductions, and credits for the year. Because the partner is no longer receiving a paycheck, she will no longer have federal, state, and local income tax withholding paid in on her behalf to the various taxing authorities. Thus, the new partner will need to make quarterly estimated tax payments. This may come as a big surprise to a new partner. Proper tax and cash-flow planning allows the new partner to budget for these quarterly payments.
Other items a new partner should consider include:
- A partnership agreement should be in place and carefully reviewed to understand certain rules regarding admission and withdrawal provisions, capital contribution requirements, profit and loss allocations, indemnification rights, and transferability of equity interest.
- A compensation agreement should clearly list the guaranteed payments that replace salary and fringe benefits. Guaranteed payments include fixed periodic compensation and are paid to partners even if the partnership is reporting losses. Any payments made by the partnership on behalf of the partner could be classified as guaranteed payments and subject to Self-Employment (SE) Tax. Partners should receive an itemized list of guaranteed payments annually to help their tax advisor identify certain deductions such as payments for health insurance and retirement contributions.
- Unlike an employee, a partner must pay both the employer-portion AND the employee-portion of the SE Tax (as a W-2 employee, the individual only had to pay the employee-portion of the tax). As previously mentioned, these payments will need to be made via quarterly estimated tax payments. The partner, however, will be entitled to a deduction on her income tax return equal to one-half of the total SE tax.
- Multi-state income tax reporting is one of the biggest tax challenges that comes with making partner. If the partnership is required to file a tax return in multiple states, each partner may also need to file tax returns in those states. To mitigate this responsibility, new partners should consider being included in the partnership state composite tax returns, if applicable, or request that the partnership make nonresident income tax withholding payments on their behalf. A careful state income tax analysis should be prepared to determine the treatment that accomplishes the most tax savings.
- Inquire about any firm-related foreign activities and determine your exposure. Merely having a signatory authority will require a partner to comply with foreign disclosures and reporting.
- Partners should work with their tax advisors to keep records of their tax basis. Tax basis is your capital investment in the partnership for tax purposes and becomes essential when the partnership reports overall losses or gives distributions. Having adequate basis allows a partner to deduct partnership losses and/or receive distributions tax-free. Keeping track of your tax basis annually reduces the amount of work required by a tax advisor in a year in which the basis could be questioned.
It is a wonderful zenith of your professional journey to be retained for knowledge and compensated with equity ownership. It is also the right time to equip yourself with trusted advisors to help you navigate this transition through tax consulting and wealth preservation.
Drucker & Scaccetti has decades of experience in helping transitions from employee to partner. Being prepared is half the battle. Noncompliance of some requirements, like making estimated tax payments, can be costly. If you are in this transitional state, or are about to be, call on us. We’d be happy to conduct a confidential consultation to discuss your options and help plan for a smooth and fruitful transition.