How are Partners Compensated?
Partners do not receive a salary from the partnership. Rather, the partners a compensated by withdrawing funds from partnership earnings. Partnerships are flow-through tax entities. As such, any profits or losses produced by the partnership pass through to the partners. This is known as that partner’s distributive share. By default, partners share equally in the profits or losses of the partnership. The partners may allocate profits and losses as they desire through the partnership agreement. The only limitation is that there must be a economic reason (“substantial economic effect”), other than tax avoidance, for the special allocation of profits or losses. In some cases the partnership may retain any earnings. In this case, the partners are still responsible for paying taxes on the earnings as if they had received it as income. This is known as “phantom income”.
Though the partnership is not a taxable entity, the partnership must still file an informational return to the IRS. The partnership produces K-1 forms that provides owners with information regarding their share of partnership profits or losses. The owners use the K-1 to report these profits or losses on their personal income tax returns.