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A business taxed as a partnership, whether a general partnership or a limited liability company (whose owners are referred to as “members” and not as “partners”), is not perceived as an entity existing separately from the partners or members for income tax purposes insofar as a business taxed as partnership is not a taxable entity under federal or state law. The income, gains, losses, credits, and deductions of a such a business are “passed through” to the partners or members based on each partner’s or member’s share in these items, as usually agreed to in the “partnership agreement,” or “operating agreement” if a limited liability company.
Partners and members are taxed on partnership or limited liability company income, whether distributed or not, at the individual tax rates of each and, where they incur losses, are allowed to take certain types of deductions against other income they might have. This may be of special importance to a newly started business that expects to generate losses in its formative years. Such losses can be used to offset income from other sources. Losses may be deducted, however, only to the extent of an individual partner’s or member’s investment in the business. Losses which exceed this amount may be deducted in subsequent tax years only if the partner or member increases his, her, or its investment in the partnership or the limited liability company.
Although a partnership (or a limited liability company taxed as a partnership) itself pays no tax, it must file an information return to the IRS on Form 1065, U.S. Partnership Return of Income, and to the South Carolina Department of Revenue on Form SC-1065. These forms show the financial result of the partnership’s operations for its tax year and the items and their proportions that must be “passed through” to the partners or members. Each partner or member, in turn, receives a copy of Schedule K from the business showing his or her share of income, deductions, credits, and losses, which will be then appended to the partner’s or member’s income tax return.
To keep track of each partner's financial status within the partnership, the partnership must establish a capital account for each partner. The term "capital account" is an accounting term referring to a general ledger technique designating the equity of each partner in a business—that is to say, the partner's share of the amount of the excess (if any) of the partnership's assets (including, but not limited to, cash) minus its liabilities. Transactions causing a decrease in the amount owed to partners, such as a withdrawal of cash by a partner, are recorded as a debit. Transactions causing an increase in the amount owed to partners are recorded as credits.
To make the concept of "capital accounts" more clear, a useful way to think about capital accounts is that they generally serve the same function in tracking the economic relationship of partners to the partnership as individual bank accounts keep track of the economic relationship depositors have with a bank. Although banks do not distribute their profits to depositors as do partnerships, each depositor’s bank account is little more than a statement tracking his or her share of the general pool of capital held and used by the bank, starting with the depositor’s initial deposit, crediting interest payments, and debiting withdrawals.
Thus, a partner's initial capital account consists of the cash that the partner contributes to the partnership, plus the current fair market value of property that the partner has contributed, plus the amount of any partnership debts the partner has assumed. Thereafter, in the course of business, the partner's initial capital account is increased by additional contributions made by the partner plus the partner's share of partnership assets. Similarly, the partner's capital account is decreased by the amount of any cash, or the fair market value of any property, distributed to the partner by the partnership, as well as by the partner's share of any partnership losses.
The analogy between a capital account and bank account, however, has limits. Whereas a capital account reflects a partner's overall equity in the partnership, equity in a partnership is not the same as cash in the partner's bank account. Rather, the partners themselves must first agree to a distribution of partnership assets—usually cash or other property of the partnership.
A partner in a partnership (or a member of an LLC taxed as a partnership) is generally considered “self-employed” and not an employee. He or she, therefore, is not obligated to pay themselves a regular salary or wage. Moreover, he or she is also not subject to the additional administrative burden of withholding income tax or payroll taxes from each of his or her distributions of profit. Nor is a partner required to pay federal or state employment security taxes on his or her distributions. Self-employed individuals also do not count as employees for the purpose of meeting the worker’s compensation requirement threshold (generally four or more employees within twelve months) or the South Carolina Wage Payment Act threshold (generally five or more employees). Instead, self-employed individuals are required to pay income taxes and self-employment taxes (social security and Medicare) on a quarterly estimated basis. In contrast, shareholders or members who provide personal services to an entity taxed under Subchapter “C” or Subchapter “S” in exchange for compensation are considered employees with respect to such services, not unlike any other employee, and are therefore subject to the same withholding tax, payroll tax (FICA taxes), federal and state employment security taxes, and (if having four or more employees) worker’s compensation coverage and (if having five or more employees) South Carolina Wage Payment Act requirements.
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