Dozens of times over these last few weeks of tax season, I’ve found myself talking with clients and their financial advisors. And it’s clear that most lack understanding of some basic partnership tax consequences that dramatically impact not just their income tax return but also their investment returns.
Partnership Tax Consequence #1: State Tax Nexus
A first partnership tax consequence people usually don’t learn about until it’s too late.
If you invest in some partnership, partners probably need to file nonresident state income tax returns in each of the states in which the partnership operates.
For example, if you invest in some oil or gas pipeline company which is operated as a partnership and the pipeline runs through ten states, you now have nexus in ten states and may need to file tax returns in those states.
Note: “Nexus” means enough of a connection to a state that the state can assess income taxes.
And this clarification: You might assume that with only a few dollars of income apportioned to a state you don’t need to worry. But you might also be wrong about this. In our practice, we have seen states go after nonresident taxpayers because some K-1 reports between $10 and $20 of income earned within the state.
Partnership Tax Consequence #2: Complex Income and Deductions
A second partnership tax consequence reflects a basic reality of tax accounting for pass-through entities like partnerships (and also, by the way, for S corporations, trusts and estates). Income items and deductions retain their character as they flow through from the pass-through entity’s tax return onto the partners’ tax returns.
This means you’re often moving not one or two items from the K-1 you receive from the partnership into your tax return. You’re moving, potentially, dozens of income or deduction items into your tax return. Correctly accounting for many of these items requires rather specific, technical accounting knowledge.
Note: If you’re getting K-1s from a partnership that are one or two dozen pages in length, the K-1 will probably take a skilled tax accountant an hour or more to go through. Especially lengthy K-1s such as the sort produced by hedge funds can each take hours of time from a highly skilled tax accountant.
Partnership Tax Consequence #3: Expensive or Error-filled Tax Return Preparation
Related to the first two partnership tax consequences is this reality. Because you will have nexus in multiple states with a multistate partnership and because partnerships often will pass-through lots of interesting and unusual income and deduction items, you’re going to either need to outsource the return preparation to some professional who knows how to handle these babies.
Or, you’ll need to bumble your way through yourself making the sorts of errors that mean you will under-report, over-report or erroneously report both the income and the deductions.
Can I make this tangential comment? One of the most discouraging conversations a CPA has with an individual tax return client during tax season is the one explaining why the price for having a tax return prepared equaled $700 last year but equals $5,000 this year.
Closing Comments about Partnership Tax Consequences
Can I close with a couple of comments?
First, I doubt it makes sense for you to be investing in investment partnerships. We see a lot of these partnerships every year. Few look that attractive.
Second, if you decide to stick with this investment option, be sure you’ve assessed the profitability in light of the extra tax costs and complexity. In most cases that I see, the brokers haven’t done this.
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