Many employees spend the bulk of their working lives trying to become a partner of the business to which they’ve devoted so much of their time and effort. Employees are typically rewarded for their hard work and dedication, while partnerships offer the chance to retain a highly-prized asset. That said, it is important for all involved to be aware of the tax implications associated with the conversion of an individual’s employment contract to a partnership agreement.  

Employee-to-Partner Conversions

The most fundamental change for an employee becoming a partner is their basic tax forms. An employee typically gets a W-2 and files an annual tax return. Partners do not receive a W-2; instead, they get a Schedule K-1. The K-1 includes the partner’s share of the company’s income, loss, deductions and credits. Additionally, partners no longer have tax withholdings paid on their behalf and as such, they will need to make quarterly estimated tax payments. Employees and businesses will also need to consider the following possible issues:

Self-Employment Taxes

As a partner, you are now required to pay self-employment tax (the Social Security and Medicare taxes owed by individuals who work for themselves). W-2 employees have half of their Social Security and Medicare taxes withheld from their paycheck, while the employer pays the other half. However, partners are now responsible for the entire Social Security and Medicare tax.

Partnership and Compensation Agreement

The partnership agreement should discuss a number of important tax considerations. For example, it should state how profits and losses will be apportioned and it should also state any capital contribution requirements. Compensation agreements should include a list of guaranteed payments that will be paid regardless of whether the partnership reports losses. Such compensation is generally made in fixed periodic payments.

Multi-State Income Tax Reporting

When a partnership is required to file tax returns in various states, this can result in each partner needing to file returns in those same states. However, this issue can be addressed (in part) in several ways. For example, for any state other than where the partner resides, the partnership may make nonresident income tax withholdings on the partner’s behalf. Alternatively, the partner may be included in the composite state tax returns filed by the partnership.

Speak With a Boston Tax Attorney For Help

If you need more information or additional help with understanding the tax implications of an employee-to-partner conversion, or if you have already been contacted about an IRS audit, it is recommended to contact a knowledgeable Boston tax attorney.