Are Partnerships Double Taxed? A Look at Pass-Throughs

Partnerships are a common business structure, and individuals considering or involved in one often question how their income will be taxed. A common concern revolves around the concept of “double taxation,” where business profits might be taxed more than once before reaching the owners.

Understanding Double Taxation

Double taxation refers to a situation where the same income is taxed twice. This occurs in C-corporations. First, the corporation itself pays corporate income tax on its earnings at the entity level. The current federal corporate income tax rate is a flat 21%.

After the corporation pays its taxes, any remaining profits distributed to shareholders as dividends are taxed again. This two-tiered taxation, first at the corporate level and then at the shareholder level, is what defines double taxation.

How Partnerships Are Taxed

Partnerships are generally not subject to double taxation because they operate as “pass-through” or “flow-through” entities for tax purposes. Instead, the income, gains, losses, deductions, and credits generated by the partnership are “passed through” directly to the individual partners. Each partner then reports their share of the partnership’s taxable income or loss on their personal income tax return, Form 1040. The partnership provides each partner with a Schedule K-1 (Form 1065) which details their distributive share of the partnership’s various income, deduction, and credit items. Partners pay tax only once, at their individual income tax rates, on their share of the partnership’s profits, regardless of whether the cash was actually distributed to them.

For instance, if a partnership earns $100,000 in taxable income, and a partner has a 50% share, that partner will report $50,000 of income on their personal tax return. Distributions of cash or property from the partnership to partners are generally not taxable events at the time of distribution, unless the amount of the distribution exceeds the partner’s adjusted basis in their partnership interest.

Key Tax Considerations for Partners

One significant aspect is self-employment tax. General partners and limited partners who actively participate in the business are generally required to pay self-employment taxes, which cover Social Security and Medicare contributions, on their distributive share of the partnership’s ordinary business income. For 2024, the self-employment tax rate is 15.3% on net earnings up to $168,600 (12.4% for Social Security and 2.9% for Medicare), and 2.9% for Medicare on earnings above that threshold.

Another important concept for partners is their “basis” in the partnership interest. A partner’s basis represents their investment in the partnership, and it is adjusted annually. The basis increases with contributions of money or property to the partnership and with the partner’s share of partnership income. Conversely, it decreases with distributions received and the partner’s share of partnership losses. The adjusted basis is important because a partner generally cannot deduct partnership losses exceeding their basis, and it helps determine the gain or loss when a partner sells their interest.

Partners may also receive “guaranteed payments” from the partnership. These are payments made to a partner for services performed or for the use of capital, regardless of the partnership’s income. Guaranteed payments are taxable income to the partner receiving them and are generally deductible by the partnership as a business expense. These payments are also typically subject to self-employment tax for the recipient partner.

While federal income tax treatment for partnerships is generally consistent across the country, state tax laws can introduce additional considerations. Many states generally follow the federal pass-through treatment, but some may impose entity-level taxes or require additional filing requirements for partnerships operating within their borders. Partners should be aware of any specific state-level income or franchise taxes that might apply to their partnership or their individual share of its income.

Comparing Partnership Taxation with Other Business Structures

C-corporations, as discussed, are distinct because they are subject to double taxation. The corporation pays income tax on its profits, and then shareholders pay individual income tax on dividends received from those after-tax profits. This contrasts sharply with partnerships, where income is taxed only once at the individual partner level.

S-corporations offer a similar tax treatment to partnerships, as they are also pass-through entities. Like partnerships, S-corporations generally do not pay federal income tax at the entity level. Instead, their income, losses, deductions, and credits pass through directly to the shareholders, who report these items on their individual income tax returns. This structure also avoids the double taxation seen with C-corporations, making S-corporations a popular choice for smaller businesses seeking liability protection without the tax burden of a C-corporation.

Sole proprietorships are another business structure that avoids double taxation. In a sole proprietorship, the business and its owner are considered the same entity for tax purposes. All business income and expenses are reported directly on the owner’s individual income tax return, typically on Schedule C (Form 1040). The net profit or loss from the business is then subject to individual income tax and self-employment taxes, similar to a partner’s share of partnership income.