If you own a partnership business or investment with one or more partners, understanding partnership taxation is crucial. But partnership taxes can be complex and confusing.
In this comprehensive guide, we’ll demystify all the key aspects of how partnerships are taxed. Read on to learn about partnership tax returns, allocations, distributions, basis, losses, and more.
In this article you will learn:
What is a Partnership?
A partnership refers to two or more people running a trade or business together for profit. Common examples include:
Real estate investing partnerships
Joint retail businesses
Professional services firms like doctors, lawyers, and CPAs
Multi-member LLCs taxed as partnerships
Partnerships are considered “pass-through” entities since profits/losses pass through to the partners’ personal tax returns. The partnership itself does not pay income tax.
This differs from C corporations which face double taxation on corporate income and dividends.
How are Partnerships Taxed?
The taxation of partnerships centers around a few key concepts:
Taxation on personal returns - Each partner reports their share of partnership income on their personal 1040 based on schedule K-1. The partnership files an information return only.
Pass-through of income/loss - All partnership profits and deductions pass-through and retain the same tax character to the partners’ 1040 returns.
Basis tracking - Partners must track their outside basis to determine deductible losses each year.
Distributions vs. allocations - Partners pay tax on their share of income allocated, not cash distributed. Distributions impact basis.
Now let’s explore each of these elements of partnership taxation in more detail.
Partnership Tax Returns
Unlike corporations, partnerships do not pay income tax. Instead, the partnership files an annual information return, while each partner reports their share of partnership income and deductions on their personal 1040 tax return.
Form 1065 - Partnerships file a Form 1065 informational return each year. This reconciles all partnership income, deductions, credits, distributions, and partner capital accounts.
Schedule K-1 - Each partner receives a Schedule K-1 statement from the partnership detailing their allocated tax items for the year. Partners use this to report amounts on their own 1040 returns.
Form 1040 - Using the K-1, partners report their share of partnership income, deductions, credits, and carryovers on their personal tax return. This income retains the same character as if they earned it directly.
In summary, no tax exists at the partnership level. Income flows through and partners pay tax on their personal returns.
Pass-Through Taxation of Partnerships
One of the hallmarks of partnership taxation is pass-through treatment. This means:
Partnership income and deductions pass through to partners’ 1040s
These amounts retain the same tax character as if earned directly by the partner
For example, if the partnership has:
$100,000 of ordinary business income
$20,000 long-term capital gain
$50,000 rental real estate loss
These amounts flow through to the partners’ 1040s as ordinary income, capital gain, and rental real estate loss.
The character of each item is maintained, even though the partner didn’t directly earn it. This enables partners to deduct losses they might not generate individually.
How Partnership Distributions Work
partnership distributions are often confused with their allocated taxable income. But these are two entirely separate concepts:
Allocated income - Each partner pays taxes on their allocated share of partnership net income
Distributions - The amount of actual cash distributed to each partner
For example, two partners could each be allocated $50,000 of partnership income. But based on their partnership agreement, Partner A could receive a $90,000 cash distribution, while Partner B receives $10,000 in cash.
The cash distributions don’t impact taxes (just partner capital accounts). Each partner still pays tax on $50,000 of income.
Partnership distributions also impact the partners’ basis, as discussed next.
Understanding Partnership Basis
Partners must track their basis to determine the amount of partnership loss they can deduct each year. Basis originates from:
Contributions - Basis increases by the amount of cash & property contributed
Income - Allocated partnership income increases basis
Liabilities - Partner’s share of partnership debt increases basis
Meanwhile, distributions and allocated losses decrease basis. Partners cannot deduct partnership losses that would reduce their basis below zero. Excess losses get carried forward until basis is restored.
Basis is increased again as the partner contributes additional capital or the partnership generates income. Keeping detailed basis records is key to properly deducting partnership losses.
Self-Employment Taxes on Partnership Income
General partners pay self-employment (SE) tax on their entire distributive share of partnership net income. Limited partners pay SE tax only on guaranteed payments for services rendered.
SE tax consists of 15.3% tax on the first $147,000 of income in 2022, divided between Social Security and Medicare taxes.
Partnerships with Passive Activities
Tax rules limit the deductibility of passive losses - where the taxpayer does not materially participate, like in a rental real estate partnership.
Passive losses can only offset passive income from other passive activities. Excess losses get suspended and carried forward until the partner generates additional passive income to offset.
However, real estate professionals who meet material participation standards can often convert these passive partnership interests into active ones. This enables them to deduct losses against other income like W-2 wages.
Partnership Audits and Litigation Proceedings
The IRS has up to 3 years to audit partnership returns after they are filed. Any adjustments get flowed through to the partners in the adjustment year under the new centralized partnership audit regime.
Partnerships can elect to push adjustments through to the reviewed year partners instead. But this requires filing statements and amended returns for each partner, so most partnerships handle the audit at the entity level.
Takeaways on Partnership Taxation
The key takeaways on how partnerships are taxes include:
Income and deductions maintain character and flow through to partners’ 1040s
Partners pay taxes on allocated income, not cash distributions
Basis must be tracked to determine deductible losses
General partners pay self-employment tax on ordinary business income
Passive loss rules apply, but can sometimes be avoided
With multi-member LLCs and real estate partnerships so common, understanding partnership taxation is essential. Work closely with your tax advisor to ensure you properly report partnership activity.
Frequently Asked Questions on Partnership Taxes
1. How does a husband and wife partnership file taxes?
If spouses form a partnership, they would report income on their joint 1040 return like any other partners. File a partnership Form 1065 and issue each spouse a K-1. But for a solely owned entity, filing a Schedule C for sole proprietorship is simpler.
2. How are limited partnership interests taxed?
Income and deductions from a limited partnership interest flow through to limited partners’ 1040s. But limited partners generally pay self-employment tax only on guaranteed payment for services rendered.
3. What happens if I contribute property vs cash to a partnership?
Contributing property instead of cash does not trigger taxable gain. The partnership takes your same tax basis in the property. But gain could still result if leveraged property subject to debt is contributed.
4. How can I get taxed on partnership income I didn’t receive?
Partners pay taxes on allocated partnership income, not actual distributions received. If no cash is distributed, partners must pay tax out of pocket on allocations. Proper partnership agreements are key.
5. Can I deduct partnership losses against W-2 income?
Only if the loss is not passive and you have sufficient basis. Real estate professionals can sometimes convert rental real estate partnership interests into active ones to unlock loss deductions.
Putting It All Together - How Partnerships Are Taxed
Partnership taxation rules can seem convoluted. But understanding concepts like basis, distributions, and pass-through treatment is crucial for properly reporting partnership activity and maximizing tax benefits. Contact the experts at United Tax if you need help understanding how partnerships are taxed. Our seasoned partners can ensure you stay in full IRS compliance.
