Learn the essentials of this complicated subject before you file your tax return.

For many small businesses, paying income tax means struggling to master double-entry bookkeeping and employee withholding rules while ferreting out every possible business deduction. For partnerships, paying taxes also involves understanding difficult terms like "distributive share," "special allocation," and "substantial economic effect." Here, we demystify some of these complexities and explain the basics of how partnerships are taxed.

How Partnership Income Is Taxed

Generally, the IRS does not consider partnerships to be separate from their owners for tax purposes; instead, they are considered "pass-through" tax entities. This means that all of the profits and losses of the partnership "pass through" the business to the partners, who pay taxes on their share of the profits (or deduct their share of the losses) on their individual income tax returns. Each partner's share of profits and losses is usually set out in a written partnership agreement.

Filing Tax Returns

Even though the partnership itself does not pay income taxes, it must file Form 1065 with the IRS. This form is an informational return the IRS reviews to determine whether the partners are reporting their income correctly. The partnership must also provide a Schedule K-1 to the IRS and to each partner, which breaks down each partner's share of the business's profits and losses. In turn, each partner reports this profit and loss information on his or her individual tax return (Form 1040), with Schedule E attached.

Estimating and Paying Taxes

Because there is no employer to compute and withhold income taxes, each partner must set aside enough money to pay taxes on his share of annual profits. Partners must estimate the amount of tax they will owe for the year and make payments to the IRS (and usually to the appropriate state tax agency) each quarter -- in April, July, October, and January.

Profits Are Taxed Whether Partners Receive Them or Not

The IRS requires each partner to pay income taxes on his "distributive share." This is the portion of profits to which the partner is entitled under a partnership agreement -- or under state law if the partners didn't make an agreement. The IRS treats each partner as though he or she received his distributive share each year. This means that you must pay taxes on your share of the partnership's profits -- total sales minus expenses -- regardless of how much money you actually withdraw from the business.

The practical significance of the IRS rule about distributive shares is that even if partners need to leave profits in the partnership -- for instance, to cover future expenses or expand the business -- each partner will owe income tax on his or her rightful share of that money. (If your business will regularly need to retain profits, you should consider incorporating -- corporations offer some relief from this particular tax bite. To learn more, see "Incorporating Your Business May Cut Your Tax Bill," below.)

Establishing the Partners' Distributive Shares

Unless business partners make a written partnership agreement that says otherwise, state law usually allocates profits and losses to the partners according to their ownership interests in the business. This allocation determines each partner's distributive share. For instance, if Andre owns 60% of a partnership and Jenya owns the other 40%, Andre will be entitled to 60% of the partnership's profits and losses and Jenya will be entitled to 40%. (In addition, state law assumes that each partner's interest in the business is in proportion to the value of his or her initial contribution to the partnership.)

If you'd like to split up profits and losses in a way that is not proportionate to the partners' percentage interests in the business, it's called a "special allocation," and you must carefully follow IRS rules.

Self-Employment Taxes

If you are actively involved in running a partnership, in addition to income taxes, the IRS requires you to pay "self-employment" taxes on all partnership profits allocated to you. Self-employment taxes consist of contributions to the Social Security and Medicare programs, similar to the payroll taxes employees must pay.

There are some differences between the contributions regular employees make and the contributions partners must make. First, because no employer withholds these taxes from partners' paychecks, partners must pay them with their regular income taxes. Also, partners must pay twice as much as regular employees, because employees' contributions are matched by their employers. However, partners can deduct half of their self-employment tax contribution from their taxable income, which lowers their tax bill a bit.

The self-employment tax rate for 2007 is 15.3% of the first $97,500 of income and 2.9% of everything over $97,500. Partners report their self-employment taxes on Schedule SE, which they submit annually with their personal income tax returns.