A corporation distributes profits to its stockholders by issuing dividends. Partnerships share profits, but the money is called a distribution, not a dividend.
Partnerships typically divide up gains and losses according to the owners' investment in the business. For example, if one partner contributes 40 percent of the startup capital and two other partners contribute 30 percent each, that's how the business allocates profits: 40, 30 and 30 percent. The partners can agree to divide up profits differently. For example if one partner contributes 80 percent of the initial funding, but the other partner runs the business, they might choose to allocate profits 50/50. A special allocation can be used as a tax dodge, so the Internal Revenue Service will scrutinize any such arrangement carefully.
Assumptions can be a problem when forming a partnership. One partner may assume the allocation is based on capital investment, and another partner may expect a different arrangement. Drawing up a partnership agreement forces the partners to spell out the rules and negotiate disagreements. This can prevent serious problems down the road.
Allocations vs. Distributions
Allocating profits isn't the same thing as distributing them. Suppose you invest 40 percent of the startup capital, and the profits for the year are $140,000. Your allocation would be $56,000. You and your partners, however, agree to reinvest all the profits in the firm and use it to expand the business. Even though you didn't take a distribution, the IRS still treats you as having received $56,000 in taxable income. You pay tax on your share of the profits, not the amount the partnership pays out to you.
Each partner has a capital account on the books that tracks his share of the business assets. If there's no distribution, the $56,000 is credited to your capital account.
Even though the partnership doesn't pay taxes itself, it has to report income and losses to the IRS on Schedule K-1. Each partner receives a copy of the K-1 for the year with a breakdown of his allocation for the year. The partners then report their allocation as individual income on their personal tax returns.
The partnership agreement should spell out how the distributions are made each year. There are multiple ways to do this:
• Wait until the end of the year and decide how much the firm can afford to distribute.
• Allow for regular draws during the year, similar to taking a salary.
• Guarantee a large enough distribution to pay any tax on each partner's share of income.
State law may limit the amount that can be withdrawn to prevent distributions from rendering the partnership insolvent.