Taxation of partnerships and their partners
Partnerships are a popular form of association for freelancers, small and medium-sized businesses to jointly pursue an objective while sharing risks and costs. In this article you will learn what these partnerships are and how they are treated in tax law.
In this article you will learn
- what partnerships are
- how they are treated in tax law
- the procedure for determining the type of income
- how exactly the determination of profit works
1. What is a partnership?
Partnerships are associations of at least two people pursuing a common goal. A partnership can take various legal forms, such as the:
- civil law partnership (GbR)
- the general partnership (OHG)
- limited partnership (KG)
A characteristic feature of a partnership is that its profits and losses are distributed equally among the partners.
Case study for a civil law partnership
Karl, 27, trained as a baker, and Caro, 26, trained as a barista (with a soft spot for accounting). The two decide to open a small café together. Does this mean that they have already formed a partnership? Answer - yes. Karl and Caro establish a civil law partnership (GbR). Karl and Caro join forces by pursuing a common purpose: running the café. Karl bakes and Caro takes care of the bookkeeping and serving the customers. Both divide the profits between them.
(Mutter/Müller in Gummert, Personengesellschaftsrecht, 3. Auflage 2019, § 1 Rn. 22)
2. Partnerships and tax law
The transparency principle in tax law applies to partnerships, which governs the taxation of the partnership and its profits. For tax law purposes, we look through the partnership (make it transparent) and directly access the individual partners.
This means that the profits and losses of the company are allocated directly to the shareholders and taxed by them. Profits and losses are distributed among the shareholders according to the profit distribution formula specified in the partnership agreement.
3. Profit determination
When determining the profit of a partnership, a distinction must be made between two levels: the level of the partnership and the level of the partners. First, the type of income of the partnership is determined before the profit generated is distributed among the partners.
The distribution of profits is carried out according to the profit distribution key, which may result from the law or the partnership agreement. Then the actual taxation of profits and losses takes place among the shareholders.
Our case study
So what do Karl and Caro from our case study have to pay tax on?
As a first step, the type of income of the partnership is determined. Subsequently, the profit generated by the café is determined. The profit is then distributed to Karl and Caro. This can result from the law or the partnership agreement. Among other things, the profit can be distributed equally or also on the basis of a percentage quota.
3.1. Findings at the level of the company
The unity principle of the partnership states that the type of income and the profit of the partnership are determined as a whole. Although the partnership has only a limited tax subject quality, it is treated as a tax subject in order to facilitate the taxation of the partners. However, the actual taxation takes place with the partners and concerns income tax and corporate income tax.
3.1.2. Determination of the type of income
In determining the type of income, German tax law distinguishes between profit and surplus income.
As a rule, profit income is commercial income. If the partnership carries on an independent, permanent activity and generates profits, this is an original commercial activity.
IMPORTANT: There are also cases of income from profits in which an activity is considered commercial, for example if a GmbH is the only personally liable partner. If commercial income is earned in addition to other income such as rental income, this will rub off on the entire business and all income will be treated as commercial.
If you are considered a co-entrepreneur as a partner in a partnership, commercial income is also attributed to you. A co-entrepreneur has co-entrepreneurial initiative and risk. This means that he participates in the decision-making processes of the company and also has a share in the hidden reserves of the company.
Hidden reserves are the difference between the recognized value of an asset in a company and its actual value. In very simplified terms: A car still has a value of 10,000.00 euros (book value) in the balance sheet. However, the car could be sold for 15,000.00 euros (common value). There are hidden reserves in the amount of 5,000.00 euros).
Our case study
The activity of Karl and Caro is an independent, sustainable (long-term) activity. Furthermore, the two intend to make profits with the café and participate in general economic transactions. Insofar as both of them can participate in the decision-making process and share in profits, losses and hidden reserves, they generate commercial income with their café.
Surplus income includes, among other things, income from rentals and investment income such as interest or dividends from securities. If a partnership generates such income, it is an asset-managing partnership.
3.1.3. Profit level
First stage of profit determination
At the level of the company, the profit of the joint ownership (persons who jointly own assets) is determined.
The determination of the partnership's profit for tax purposes is based on commercial law. Depending on the accounting regulations under commercial law, the company prepares a trade balance or determines its profit on the basis of an income surplus statement (simple comparison of income and expenses). In the determination of profits, both the property of the company and all income and expenses related to its activities are recorded.
In the case of partnerships, the supplementary balancesare of particular importance. This results in value adjustments to the overall company. This means that no assets such as buildings, machines or cars are recorded here, but only deviations from the assessed value in the overall holding for an individual partner.
These different valuations may arise in particular if a shareholder joins the company for the first time and does not fully disclose hidden reserves or does not disclose them at all. This also applies if the granting of tax benefits depends on the personal requirements of the shareholders and therefore may not be granted to every shareholder.
The profit of the joint ownership is then determined separately by issuing an assessment notice. In this notice, the profit is distributed among the partners according to the applicable profit distribution key.
Excursus: If a loss is incurred at the level of the partnership, § 15a EStG must be observed. In the case of a limited partner (a type of KG partner), losses can only be directly taken into account to a limited extent under certain conditions.
Example: A separate and uniform assessment notice is issued. This determines the profit to be distributed and the share attributable to the shareholders.
3.2 Determination at the shareholder level
The second stage of profit determination
refers to the allocation of special profits or losses to the shareholders. This process includes the remuneration they receive from the company when, for example, they rent an office building or grant a loan.
All related income and expenses are recorded in so-called special balance sheets. The resulting profit or loss is then allocated to the respective shareholder in addition to the overall result of the collective ownership (Gesamthand)
It is therefore a separate accounting treatment of income and expenses that are directly related to the compensation that the shareholders receive from the company. This ensures that the individual contributions of each shareholder to the overall result of the company as a whole are appropriately taken into account.
4. Which taxes have to be paid by whom?
4.1. From the company
Despite the limited ability to be a "taxable entity" (see above), there are taxes that are owed directly by the partnership. These include trade tax and value added tax.
The fact that trade tax is levied and owed at the level of the company can be explained by the nature of trade tax. Trade tax is a so-called real/object tax. This means that the objectively possible earning power is taxed and not the individual performance.
If a partnership is liable to trade tax, the notice on the trade tax assessment amount and on the trade tax is issued to the partnership. The tax debtor for the trade tax is the partnership and not the individual partners.
4.2. From the shareholders
The partners pay tax on the profits from the partnership (profit from the general partnership, adjusted by the values from the supplementary balance sheet, plus the special profits or losses). If the partner is a natural person, income tax is levied on the profits.
If the shareholder is a corporation - e.g. a limited liability company (GmbH) - corporate income tax is levied. Natural persons can, under certain conditions, offset the trade tax levied at the level of the company on a pro rata basis.
In our case study, this means in conclusion: Karl and Caro record the share of the profit from the partnership that is attributable to them personally in their private tax return. They receive an income tax assessment notice. This results in either an income tax liability or credit.