2025 Houston Law Guide | Federal and Texas State Law Guidance

Tag: small-business

  • Partnership Fundamentals: What You Need to Know About Formation and Taxation

    What Exactly Is a Partnership for Tax Purposes?

    For federal tax purposes, “partnership” is defined broadly in § 761(a) as any syndicate, group, pool, joint venture, or other unincorporated organization through which a business or financial venture is carried on, provided it is not classified as a corporation, trust, or estate. Not all co-ownership arrangements qualify. For example, § 761(a)(1) and Treas. Reg. § 1.761-2(a)(2) exclude groups formed solely to hold investment property without conducting a trade or business. Likewise, co-owners of property who merely lease real estate without providing services are not treated as a partnership, but adding services can convert the arrangement into a partnership. See Treas. Reg. § 301.7701-1(a)(2).

    In other words, the IRS does not require you to file partnership papers for you to be treated as a partnership. If you and someone else are carrying on a business together—even informally—the IRS may classify you as a partnership. Simply co-owning property isn’t enough, but providing services alongside that ownership can be.

    Do You Need to File Anything Under State Law to Have a Partnership?

    Surprisingly, the answer is no. Treasury Regulation § 301.7701-1(a)(1) makes clear that a partnership may exist for federal tax purposes even without a formal entity recognized under state law. Courts look primarily to intent. In Commissioner v. Culbertson, 337 U.S. 733 (1949), the Supreme Court explained that a partnership exists when parties, in good faith and with a business purpose, intend to carry on an enterprise together and share in its profits. Contributions of labor or capital are not strictly required.

    Put simply, you don’t need to go through state filings for the IRS to treat you as a partnership. If two or more people intend to run a business and divide the profits, the law may recognize a partnership—even if no one invested money or contributed labor at the start.

    How Are Startup Costs Treated for Tax Purposes?

    When forming a partnership, certain expenses must be capitalized under § 709(a). Organizational expenses—those incident to creating the partnership and chargeable to the capital account—may be deducted up to $5,000 immediately, reduced once costs exceed $50,000, with a full phase-out at $55,000. See § 709(b). Any remaining expenses may be amortized over 180 months. Importantly, syndication fees (such as the cost of issuing partnership interests) do not qualify for this election and must be capitalized. If the partnership liquidates early, unamortized expenses may be deducted under § 165.

    In other words, some startup costs can be written off right away, but once your expenses get too high, the deduction shrinks and disappears. The balance must be spread out over 15 years. Certain fees—like those for raising capital—can never be deducted this way and must be added to the business’s long-term costs.

    How Does the IRS Decide Whether an Entity Is a Partnership or a Corporation?

    The “check-the-box” regulations in Treas. Reg. § 301.7701-3 give taxpayers flexibility. By default, unincorporated entities with more than one member are treated as partnerships, while single-member entities are disregarded as separate from their owners. Either type of entity may elect to be taxed as a corporation by filing the appropriate election. This system allows business owners to tailor tax treatment to their goals, though the choice carries long-term implications for taxation and liability.

    Put simply, if you form an LLC, the IRS has default settings: one owner means it’s ignored for tax purposes, two or more owners means it’s treated as a partnership. But you can “check the box” to be taxed as a corporation if that makes more sense for your goals. The choice is powerful but also sticky, so it should be made carefully.

    What Should I Think About When Choosing Between a Partnership and a Corporation?

    The decision between a flow-through entity and a corporation depends on multiple factors. Partnerships avoid entity-level tax and allow losses to flow through to partners. Corporations, by contrast, can defer shareholder-level tax but face double taxation on distributions. Other considerations include the availability of the § 199A deduction, exposure to employment taxes, local filing fees, creditor protection, and the ability to raise capital. No single factor controls; the optimal choice depends on the owners’ income profile and long-term strategy.

    In other words, partnerships usually mean simpler taxes because profits and losses go straight to the owners. Corporations can help with liability protection and raising money, but they come with extra layers of tax. The right choice depends on your income level, risk tolerance, and long-term plans.

    How Does the § 199A Deduction Work for Partnerships?

    Section 199A provides a deduction equal to the lesser of (1) 20% of qualified business income (QBI) or (2) 20% of taxable income reduced by net capital gains. See § 199A(a). QBI for each trade or business is further limited to the greater of (i) 50% of W-2 wages or (ii) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of qualified property. § 199A(b)(2).

    The deduction is subject to income thresholds. For 2022, the phase-out begins at $170,050 for single filers and $340,100 for joint filers, fully phasing out at $220,050 and $440,100. § 199A(b)(3).

    Specified Service Trades or Businesses (SSTBs)—including law, accounting, consulting, financial services, athletics, and other fields where the principal asset is the reputation or skill of the owners—are further restricted. See § 199A(d)(2). For high-income taxpayers, SSTB income may be partially or entirely excluded from QBI.

    Finally, guaranteed payments under § 707(c) do not count as QBI. Nor do payments to partners acting in a non-partner capacity under § 707(a). In addition, Treas. Reg. § 1.199A-5(c)(2)(i) provides that if a trade or business provides property or services to an SSTB and both are commonly owned (50% or more), that portion of income is recharacterized as SSTB income.

    Put simply, § 199A is a valuable tax break that allows many business owners to deduct up to 20% of their income. But it comes with lots of caveats: income limits, restrictions for service professions like law and accounting, and rules against manipulating related businesses to qualify. Whether you get the deduction depends on your income level, industry, and how your partnership pays partners.s to partners acting in a non-partner capacity under § 707(a). In addition, Treas. Reg. § 1.199A-5(c)(2)(i) provides that if a trade or business provides property or services to an SSTB and both are commonly owned (50% or more), that portion of income is recharacterized as SSTB income.

  • Cash vs. Accrual for Partnerships: IRS Rules, Exceptions, and Tax Planning

    Choosing an accounting method determines when your partnership recognizes income and deductions. For many partnerships the cash method defers tax until money actually changes hands; the accrual method accelerates recognition when the right to receive or the obligation to pay arises. Federal law restricts who may use cash accounting. Under I.R.C. § 448(a)(2), a partnership cannot use the cash method if any partner is a C corporation, unless an exception applies. Two principal exceptions are (i) when the C-corporation partner is a personal service corporation (PSC) (§ 448(b)(2)), and (ii) when the partnership’s average annual gross receipts for the preceding three taxable years do not exceed $25 million (§ 448(b)(3)). In addition, a partnership may not use the cash method if it is a “tax shelter” as defined for these purposes in § 461 (§ 448(a)(3)).

    What the cash–accrual choice actually changes

    Under cash accounting, your partnership recognizes $1 of income only when it receives $1 of payment, and a deduction only when it pays the expense. Under accrual accounting, your partnership recognizes income when all events fix the right to receive it and the amount is determinable with reasonable accuracy, and it deducts expenses when all events have occurred that establish the liability and the amount can be determined with reasonable accuracy (subject to the economic performance rules). The difference is purely timing, but timing drives tax.

    Illustrative timing example

    • Facts. On December 28, Year 1, the partnership provides services and invoices $900,000 payable on January 15, Year 2. It also receives an invoice for $300,000 of deductible services performed in late December, which it pays on January 10, Year 2. Assume a 30% combined marginal rate for the partners.
    • Cash method (permitted only if eligible under § 448).
      Year 1 income recognized: $0 (no cash received)
      Year 1 deductions: $0 (no cash paid)
      Year 1 tax on these items: $0
      Year 2 recognizes $900,000 income and $300,000 deductions, for $600,000 net; tax at 30% = $180,000 in Year 2.
    • Accrual method.
      Year 1 income recognized: $900,000 (fixed right to payment)
      Year 1 deductions: $300,000 (fixed liability; economic performance satisfied)
      Year 1 net income: $600,000; tax at 30% = $180,000 in Year 1.

    Same amount of tax, different year. Cash accounting can be attractive when receivables are large at year-end; accrual can be preferable when you routinely incur significant unpaid expenses at year-end.

    The C-corporation partner limitation and the PSC exception

    If a partnership has any C-corp partner, § 448(a)(2) says the partnership cannot use the cash method—unless the C-corp is a PSC (§ 448(b)(2)). A PSC generally is a C corporation whose principal activity is the performance of personal services (for example, law, accounting, health) substantially performed by employee-owners. If your only corporate partner is a PSC, the bar in § 448(a)(2) does not apply, and you may still use cash accounting provided no other restriction applies (e.g., being a tax shelter).

    PSC exception example

    • Facts. P is a three-member partnership providing consulting services. Partners A and B are individuals. Partner C is a PSC. P’s three-year average gross receipts are $38 million.
    • Result. Despite exceeding $25 million, P may still use the cash method because its C-corp partner is a PSC under § 448(b)(2) (and assuming P is not a tax shelter under § 461). If Partner C were a regular C-corp, P would be pushed to accrual under § 448(a)(2).

    The small-partnership gross receipts exception

    Even with a non-PSC C-corp partner, a partnership can use cash accounting if it qualifies as a small partnership under § 448(b)(3)—i.e., its average annual gross receipts for the prior three taxable years do not exceed $25,000,000.

    Computing the three-year average: step-by-step

    • Facts. Gross receipts were: Year −3: $22,000,000; Year −2: $24,000,000; Year −1: $26,000,000.
    • Average. ($22m + $24m + $26m) / 3 = $24,000,000.
      Because $24m ≤ $25m, the partnership may use the cash method (§ 448(b)(3)), even if one partner is a non-PSC C-corp and the partnership is not a tax shelter.
    • If Year −1 had been $30,000,000:
      Average = ($22m + $24m + $30m)/3 = $25,333,333 → exceeds $25m → must use accrual (unless the PSC exception applies).

    “Cliff” year illustration with tax impact

    • Facts. In Year 1 your three-year average first exceeds $25m, forcing a switch to accrual for Year 1. On January 1 you have $8,000,000 of accounts receivable and $3,000,000 of accounts payable carried over from Year 0 under cash accounting.
    • Method change mechanics. A change in accounting method generally requires IRS consent and a § 481(a) adjustment to bring previously unrecognized items into income (or expense). Here, the positive § 481(a) adjustment is typically the net of receivables minus payables not previously recognized under cash: $8m − $3m = $5,000,000 added to income. If taken into account over four years (common for positive adjustments), the partnership picks up $1,250,000 per year, increasing partner-level tax accordingly.
    • Tax effect (30% combined rate): Additional $375,000 tax per year for four years. Planning ahead to manage receivables and payables before the switch can materially soften the blow.

    The “tax shelter” prohibition

    Even if the PSC and gross receipts exceptions would otherwise allow cash accounting, a partnership cannot use the cash method if it is a tax shelter (§ 448(a)(3)). For these purposes “tax shelter” is determined under § 461. While most operating partnerships will not be tax shelters, arrangements promoted to generate tax benefits without corresponding economic substance can fall within the definition. If a partnership is a tax shelter, it must use accrual—no small-partnership or PSC relief.

    Tax shelter screen example

    • Facts. Partnership Q has average receipts of $9 million and no corporate partner. It markets interests to outside investors primarily for projected tax losses.
    • Result. If Q is a tax shelter within the meaning of § 461, § 448(a)(3) disqualifies it from the cash method despite being under $25m and lacking a C-corp partner. Q must adopt accrual.

    Strategic considerations when you can choose

    Where cash accounting is permitted, partnerships with long receivable cycles often benefit from deferral. Conversely, capital-intensive businesses with significant year-end payables (or cost accruals) may find accrual advantageous. Your choice can also interact with other provisions (for example, inventories and cost capitalization rules) and with how income is allocated among partners.

    Side-by-side tax deferral math

    • Facts. Year 1 billings of $5,000,000 are invoiced in late December and collected in January; deductible Year 1 services of $1,500,000 are invoiced in December and paid in January. Assume no other differences and a 30% combined marginal rate.
    • Cash method (eligible partnership):
      Year 1 recognizes $0 of the late-December billings and $0 of the unpaid expenses → $0 current-year tax on those items.
      Year 2 recognizes $5,000,000 − 1,500,000 = $3,500,000 net → $1,050,000 tax.
    • Accrual method:
      Year 1 recognizes $5,000,000 − 1,500,000 = $3,500,000 net → $1,050,000 tax.
      Deferral from cash method: $1,050,000 moved from Year 1 to Year 2. The total tax is the same; the time value of deferral is the advantage.

    Common transition pitfalls and how to avoid them

    1. Crossing the $25m threshold unknowingly. The three-year average can creep up quickly. Model your receipts quarterly so you are not surprised by a forced switch under § 448(b)(3).
    2. Ignoring aggregation/affiliation effects. Related-party gross receipts may be aggregated for the test under the statute and regulations; organizational changes can move you over the threshold.
    3. Missing the consent process. Changing methods generally requires a Form 3115 filing and a properly computed § 481(a) adjustment. Skipping this can lead to audit exposure and duplicate income.
    4. Assuming the PSC exception applies. Verify that a corporate partner meets the PSC definition; otherwise, the presence of a regular C-corp forces accrual (§ 448(a)(2)).
    5. Overlooking the tax-shelter rule. If the structure could be characterized as a tax shelter under § 461, cash accounting is off the table (§ 448(a)(3)) regardless of receipts.

    Quick reference to governing provisions

    • Cash method limitations for partnerships with C-corp partner: I.R.C. § 448(a)(2)
    • PSC exception: § 448(b)(2)
    • Small-partnership gross receipts exception (three-year average ≤ $25m): § 448(b)(3)
    • Tax shelter prohibition (by reference to § 461): § 448(a)(3)
    • Tax shelter definition context: § 461
    • Method change conformity (general adjustment rule): § 481(a) (for transitions)