Limited or general, a partnership could allow your ISP business to reward itself with some interesting tax benefits—as long as you choose your partner wisely.

by Mark E. Battersby [March 21, 2001]

A partnership is merely an unincorporated ISP business with two or more owners. Surprisingly, a partnership is not a taxable entity under our tax rules—there is no separate partnership income tax as there is a corporate income taxes. Business partnerships are a so-called pass-through entities. Income from an ISP partnership is taxed to the individual partners, at their own individual tax rates.

Generally speaking, if your ISP operation will be or is currently owned by several individuals, you'd want to take a look at structuring the operation as a partnership. Although partnerships come in two varieties—general partnerships and limited partnerships—most ISPs should consider their operation to be a general partnership.

The limited partnership is usually reserved for situations where investors are brought into a business without being given a say in the day-to-day operations. However, unless the ISP business expects to have many passive investors, a limited partnership is generally not the best choice for an ISP because of all the required filings and administrative complexities. In an ISP business with two or more partners—who all want to be involved in day-to-day operations—a general partnership would be much easier to structure to form and operate.

Togetherness tradeoffs
One of the major advantages of a partnership is the tax treatment that it enjoys. A partnership does not pay tax on its income—instead it passes through any profits or losses to the individual partners. At tax time, the partnership files a Form 1065, Partnership Income Or Loss. Each partner receives a copy of Schedule K-1 from the Form 1065 filing, which indicates his or her share of partnership income, deductions, and tax credits.

Each partner is required to report profits from the partnership on his or her individual tax return. For tax purposes, all of the income of the partnership must be reported as distributed to the partners. This is true whether or not the partners actually received their share 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—that is, 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 operation usually generates losses rather than profits. The partnership form of doing business allows the partners to use those losses to offset other income that they might have from investments, a job or another business.

Be warned, there is one caveat—the partners may not deduct losses that exceed the amount of their investment in the business. Of course, any losses that can't be deducted as the result of this rule can be deducted in subsequent years if the partner increases his or her investment in the ISP business deal.

Secure requital
A partnership, as mentioned, can divide its profits or losses among the partners in any manner it decides so long as there is a legitimate business purpose for the split. The partnership can also pay, compensate, or reward one or more of the partners because they have invested more money or are more active in the ISP operation. This usually takes the form of guaranteed payments.

Any fixed payment made to partners for services or for the use of capital are generally treated as though paid to a nonpartner—for the purposes of computing partnership gross income and business expense deductions. In other words, guaranteed payments are regarded as ordinary income to the recipient and are deductible by the partnership as ordinary and necessary business expenses—assuming in fact these payments are both ordinary and necessary.

My partner did what?
Personal liability should be a major concern of any ISP business that uses a general partnership to structure their enterprise. Similar to a sole proprietorship, general partners are personally liable for the business's obligations and debt. In fact, each general partner can act on behalf of the partnership, take out loans, and make business decisions that will affect and be binding on all of the partners—if the general partnership agreement permits partners to act in such day-to-day operations.

The conversion of a partnership into a limited liability company (LLC) classified as a partnership does not terminate the tax benefits of operating your ISP as a partnership. The conversion is not a sale, exchange, or liquidation of any partnership interest, the partnership's tax year does not close and the LLC may continue to use the partnership's taxpayer identification number (TIN). We'll find out more about these unusual business entities and how they might benefit your ISP operation, next week.

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