When you're a member of a partnership, you pay tax like a sole proprietor. The partnership itself doesn't pay income tax. Instead, the company divides income and expenses among you and your partners, all of whom can choose to distribute everything the partnership earned this year. You can also agree to retain a share of the earnings in the partnership accounts as a cushion against next year's spending.
You don't have to wait until the end of the year to get your partnership money. Typically, a partnership sets up a capital account representing your investment in the company and a withdrawal account. You take withdrawals as spelled out in the partnership agreement, and they're credited to the withdrawal account. At the end of the year, the bookkeeper adjusts your capital account to reflect your withdrawals and your share of the company earnings.
Retained earnings count as taxable income, even though you don't touch the money. Suppose you belong to a two-person partnership and this year's earnings are $60,000. You and your partner withdraw $25,000 each, and the partnership retains the remaining $10,000. You pay income tax on your share of the earnings, less expenses. If your share is $30,000, it doesn't matter whether the partnership retains some of the earnings or distributes them all; it all counts as your income either way.
Normally, your share of the earnings -- "distributive share" is the legal term -- is based on your ownership stake. Say you invest $60,000 in the firm and your two partners invest $30,000 each, you divide earnings 50/25/25. This applies to the earnings you withdraw and to the retained earnings. If the partnership retains $20,000 in earnings this year, $10,000 of that would be your income. Your partners each would have $5,000 in added income.
You not only pay income tax on your share of earnings, retained or not, but you also pay self-employment tax. The tax is how self-employed people pay into Social Security and Medicare. Considering you're not an employee of the partnership, you qualify. As of 2013, the tax is 15.3 percent, which represents both the employer and employee share of the tax. You can claim half of the tax you pay as a deduction on Form 1040.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.