How are Partnerships Taxed?  | Optima Tax Relief

Partnerships are a popular business structure for entrepreneurs looking to combine resources, expertise, and share profits. However, the taxation of partnerships can be complex, as the partnership itself isn’t taxed like a corporation. Instead, partnerships are subject to “pass-through” taxation, where the profits and losses pass through to individual partners. This guide explores how partnerships are taxed, the reporting requirements, and the key factors that partners should be aware of. 

Understanding Pass-Through Taxation 

Partnerships are considered “pass-through” entities, meaning they do not pay income tax at the business level. Instead, the income or loss is passed through to the individual partners. The partners then report their share of the profits or losses on their personal tax returns. This structure avoids double taxation (taxing both the entity and the owners), which is a feature of corporate taxation. 

Each partner’s share of the partnership’s income, deductions, and credits is determined by the partnership agreement. If no partnership agreement exists, the default rules provided by state law. For example, if Partner A has 50% ownership and Partner B has 50% ownership, they will each claim 50% of the company’s profits or losses. However, if Partner A has 70% ownership, they would claim 70% of the company’s profits or losses, while Partner B would claim the remaining 30%. 

The Role of Schedule K-1 

For tax purposes, partnerships must file an informational return, Form 1065, U.S. Return of Partnership Income, with the IRS each year. This return is due by the 15^th day of the third month following the date the tax year ended for the business. For example, if your business follows a calendar year (January 1 – December 31), the due date would be March 15. However, if your company has a fiscal year of July 1 – June 30, the due date would be September 15.  

Form 1065 reports the partnership’s total income, deductions, and other tax-related information. Along with Form 1065, the partnership provides each partner with a Schedule K-1, which details the partner’s share of the partnership’s taxable income, deductions, and credits. Schedule K-1 is due by March 15^th for S-corps and LLCs, and by April 15^th for trusts and estates. Alternatively, it is due on the 15^th day of the third month after the company’s tax year ends. Each partner uses the K-1 to report their share of the partnership’s tax attributes on their individual tax return (Form 1040).  

How Partnerships Distribute Income and Deductions 

In a partnership, the distribution of income and deductions is typically governed by the terms outlined in the partnership agreement. This agreement specifies how the partnership’s profits and losses are allocated among the partners. If no partnership agreement exists, or if it doesn’t specify how income and deductions are divided, the default rule under most state laws is that profits and losses will be split equally among the partners, regardless of their contributions.  

The income distributed to each partner is subject to taxation. This is true whether or not the partnership distributes the profits to the partners in cash. This means that even if the partnership retains its profits in the business, partners must still pay taxes on their share of the income. In addition to reporting income, the Schedule K-1 may include other items that affect a partner’s tax liability, such as: 

• Capital gains and losses 

Self-Employment Taxes for Partners 

A key aspect of partnership taxation is that general partners are considered self-employed for tax purposes. This means they must pay self-employment tax on their share of the partnership’s income. The self-employment tax rate is 15.3%, which includes both the Social Security (12.4%) and Medicare (2.9%) portions.  

Limited partners, however, generally are not subject to self-employment tax on their share of the partnership’s income unless they are actively involved in managing the business. The income allocated to limited partners is typically passive income and may include dividends, interest, capital gains, or other investment-related earnings. Despite this exemption, limited partners still pay income taxes on their share of the partnership’s profits, which is reported on their personal tax return using Schedule K-1. This income is usually taxed at the ordinary income rate unless it qualifies for capital gains treatment or other tax-favorable categories.  

Basis in a Partnership 

A partner’s basis in the partnership refers to the amount of their investment in the business and is important for determining the taxability of distributions and gain or loss on the sale of a partnership interest. In simpler terms, think of it as your “ownership value.” Here’s how basis works in simple terms: 

1. Initial Investment: When you first put money into a partnership, that amount is your starting basis. For example, if you invest $10,000 into a business, your basis is $10,000. 

2. Adjustments Over Time: As time goes on, your basis can change. It can increase if you put more money into the business or if the business makes profits that are allocated to you. It can also decrease if you take money out (distributions) or if the business loses money that is passed on to you.  

Your basis helps the IRS figure out how much tax you’ll owe when you take money out or sell your interest in the business. For example, if you sell your share for more than your basis, you’ll have a taxable gain. However, if you take money out of the business, it’s usually not taxable as long as it’s less than your basis. 

Partnership Losses 

Partnerships can also pass through losses to their partners. These losses can offset the partners’ other income on their personal tax returns. However, the ability to deduct partnership losses is subject to limitations such as: 

Basis Limitations 

Losses can only be deducted to the extent of the partner’s adjusted basis in the partnership. For example, let’s say you invest $10,000 in a partnership, making your basis $10,000. The partnership incurs a $15,000 loss for the year and your share of that loss is $12,000. Since your basis is only $10,000, you can only deduct $10,000 of the loss this year. The remaining $2,000 cannot be deducted now but can be carried forward to future years, when your basis increases (e.g., through additional investment or profits). 

At-Risk Limitations 

Partners can only deduct losses to the extent they are financially at risk for the partnership. This usually means the amount of money or property you personally invested and any amounts you’ve personally guaranteed. You invest $10,000 in a real estate partnership, but you also personally guarantee a $20,000 loan the partnership takes out. This puts your total at-risk amount at $30,000. The partnership then generates a $35,000 loss for the year, and your share of the loss is $25,000. You can deduct up to $30,000 (your at-risk amount) even though the partnership loss exceeds it. The remaining $5,000 loss can’t be deducted and is carried forward to future years when your at-risk amount increases. 

Passive Activity Loss Limitations 

Losses from passive activities, such as a rental business, can generally only offset income from other passive activities, not wages or other earned income. For example, say you invest in a rental property that generates a $10,000 loss for the year. You also have a full-time job, earning $60,000 in wages. Under the passive activity loss rules, you can’t use the $10,000 rental loss to reduce your $60,000 in wages because the rental property is a passive activity. However, if you also have $8,000 in passive income from another rental property or business, you can use part of the $10,000 loss to offset that passive income. The remaining $2,000 loss can be carried forward to future years when you have more passive income. 

Partnership Tax Filing Requirements 

While partnerships do not pay income taxes directly, they still have several important filing responsibilities. The first of which is Form 1065, U.S. Return of Partnership Income. Again, this informational return reports the partnership’s total income and deductions for the year. Next, the partnership will need to issue Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. to each partner. This will provide the necessary information for their individual tax returns. It’s also crucial to stay on top of state tax filings. Some states require partnerships to file their own returns or pay entity-level taxes. Additionally, if the partnership operates in multiple states, it may be subject to tax filings in each of those states. 

Tax Help for Partnerships 

The taxation of partnerships can be complex. Understanding how pass-through taxation works, the role of Schedule K-1, and the treatment of self-employment taxes, basis, and losses is crucial for partners. By staying informed and working with tax professionals, partnerships can navigate these rules effectively and ensure they comply with their federal and state tax obligations. Optima Tax Relief is the nation’s leading tax resolution firm with over $3 billion in resolved tax liabilities.    

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