250 Planning and Forecasting
Partnerships
Partnerships are also not separate taxable entities for the purposes of the fed-
eral 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 ad-
dition, each partner is taxed upon his or her proportion of the income of the
partnership regardless of whether that income was actually distributed.
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 expen-
diture would not lower the business’s profits by that amount. As a capital ex-
pense 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 ex-
penditure, 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 obligation is considered less of a problem since it can
be expected that the owner would manage cash f low in a way which would min-
imize this negative effect upon her- or himself.
As with a sole proprietorship, this negative result becomes a positive one
if the partnership is losing money. The losses appear on the partners’ individ-
ual tax returns in the proportions set forth in the partnership agreement and
render an equal amount of other wise taxable income tax free. In addition, not
all losses suffered by businesses result from the dreaded negative cash f low. 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-f low basis, but the de-
preciation generated by the earlier addition of the deck might well result in a
loss for tax purposes. Thus, with enough depreciation a partner might have the
double benefit of a tax sheltering loss on his tax return 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 cur-
rent tax-sheltering loss while generating a long-term capital gain for a few years
hence.
Corporations
Corporations are treated as separate entities for federal income tax purposes,
consistent with their treatment for most other purposes. They have their own
set of progressive tax rates, moving from 15% for the first $50,000 of income,
through 25% for the next $25,000, to 34% and 35% for amounts above
that. There are also 5% and 3% additional taxes at higher levels of income to