Partnerships are considered pass-through entities by the IRS — they are not separate from their owners. All profits and losses pass through the business to the partners; each pays taxes on his or her share of the profits or deducts his or her share of the losses on individual income tax returns. The portion paid depends on each partner's distributive share the share of profits the partner is entitled to under the partnership agreement.
According to the IRS rule about distributive shares, even if partners need to leave profits in the partnership — to cover future expenses or expand the business, for example — each partner owes income tax on his or her rightful share of that money.
This is why each partner needs to set aside enough money to pay taxes on his or her share of annual profits — there's no employer to withhold income taxes. Partners must estimate the amount of tax they owe for the year and make quarterly payments to the IRS and the appropriate state tax agency.
Also, contributions to Social Security and Medicare programs, similar to the payroll taxes employees pay — self-employment taxes — are required on all partnership profits. Still, partners can deduct half their self-employment tax contribution from their taxable income, lowering the tax bite.
Remember, there's no way around this. Even if there's no partnership agreement, the partners are bound by state law. Partners must pay taxes on their share of the partnership's profits—total sales minus expenses — regardless of how much money is actually withdrawn from the business.
But the good news? Partners don't have to pay taxes on most of the money the business spends on legitimate business expenses, which are deducted from your business income, thus lowering the profits to report to the IRS. Start-up costs; travel outlays, including meals and entertainment; operating expenses; and product/advertising spending are acceptable.
So what forms do you need to file? An informational return, Form 1065, which checks whether partners are reporting income correctly; a Schedule K-1, breaking down each partner's share of the business's profits and losses; and a Schedule E, which is attached to each partner's 1040, detailing profit and loss info. Don't forget that self-employment taxes are reported on a Schedule SE and submitted annually with personal income tax returns.