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Partnerships are also not separate taxable entities for the purposes of the federal income tax, although,
in most cases, they are required to file informational tax returns with the IRS. Any profits generated
by a partnership appear on the federal income tax returns of the partners, generally in proportions
indicated by the underlying partnership agreement. Thus, as with sole proprietorships, this profit is
taxed at the individual partner‟s highest marginal tax rate, and the lower rates for the initial income of
a separate taxable entity are forgone. In addition, each partner is taxed upon his or her proportion of
the income of the partnership, regardless of whether that income was actually distributed.
Exhibit 8.3 Corporate federal income tax rates.
As an example, if Bruce and Erika, our hotel magnates, were to take $50,000 of a year‟s profits to
add a deck to one of their properties, this expenditure would not lower the business‟s profits by that
amount. As a capital expense it may be deducted over time only in the form of depreciation. Thus,
assuming they were equal partners, even if Michael had objected to this expenditure, each of the three,
including Michael, would be forced to pay a tax on $16,667 (minus that year‟s depreciation) despite
having received no funds with which to make such a payment. The result would be the same in a sole
proprietorship, but this rule is considered less of a problem since it can be expected that sole owners
would manage cash flow in a way that would minimize this negative effect on themselves.
As with a sole proprietorship, this negative result becomes a positive one if the partnership is losing
money. The losses appear on the partners‟ individual tax returns in the proportions set forth in the
partnership agreement and render an equal amount of otherwise taxable income tax free. In addition,
not all losses suffered by businesses result from the dreaded negative cash flow. As illustrated earlier
in the case of the deck, the next year the hotel business might well break even or show a small profit
on a cash flow basis, but the depreciation generated by the earlier addition of the deck might well
result in a loss for tax purposes. Thus, with enough depreciation partners might have the double
benefit of a tax-sheltering loss on their tax returns and ownership of a growing, profitable business.
This is especially true regarding real estate, such as the hotel itself. While generating a substantial
depreciation loss each year, the value of the building may well be increasing, yielding the partners a
current tax-sheltering loss while at the same time generating a long-term capital gain a few years
hence.