Federal Taxation of Partnerships and Partners

For federal tax purposes, a partnership is a business with two or more owners that has not incorporated. This arrangement is a “pass-through” entity, meaning the business itself does not pay income tax. Instead, all financial results, including income, deductions, and credits, are passed directly to the partners who report them on their personal tax returns. This structure avoids the double taxation that can occur with corporate business forms.

The Partnership’s Tax Reporting Responsibilities

While a partnership does not pay federal income tax, it must report its financial activities to the IRS by filing Form 1065, U.S. Return of Partnership Income. This annual information return details the partnership’s income and deductions. The due date is the 15th day of the third month after the partnership’s fiscal year ends, which is March 15 for calendar-year businesses.

Form 1065 is used to calculate the partnership’s ordinary business income or loss. This figure represents the net profit or loss from the business’s main operations. It is calculated by subtracting the cost of goods sold and other allowable business deductions from total revenues.

A part of the Form 1065 filing involves reporting “separately stated items.” These are types of income, gains, losses, and deductions not included in ordinary business income because they are subject to different tax rules on a partner’s return. For example, capital gains, charitable contributions, and interest income are all separately stated to ensure they retain their unique tax character.

After these calculations, the partnership prepares a Schedule K-1 for each partner. This schedule breaks down each partner’s specific share of the total amounts reported on Form 1065. The allocation of these items is determined by the profit and loss sharing ratios in the partnership agreement.

The partnership sends a copy of the Schedule K-1 to each partner and files all K-1s with the IRS. The partnership must also designate a “partnership representative” who has the sole authority to act on its behalf during an IRS audit.

How Individual Partners Are Taxed

Each partner uses the information from their Schedule K-1 to report their share of the partnership’s financial results on their personal income tax return, Form 1040. For instance, ordinary business income is reported on Schedule E, while capital gains are reported on Schedule D.

Partners are taxed on their share of the partnership’s income in the year it is earned, regardless of whether they receive a cash distribution. This means a partner could owe tax on partnership income even if they did not take any money out of the business. The tax liability is tied to the allocation of profit, not the flow of cash.

Partners are considered self-employed individuals, not employees, and do not receive a Form W-2. This status requires most partners to pay self-employment tax, which covers Social Security and Medicare. This tax is calculated on their share of the partnership’s ordinary income and reported on Schedule SE.

Payments made to a partner for services or the use of capital that are not based on their share of profits are known as “guaranteed payments.” For the partnership, these payments are typically a deductible business expense. For the receiving partner, they are treated as ordinary income subject to both income and self-employment tax.

Understanding a Partner’s Basis

A partner’s basis, or “outside basis,” is a measure of their economic investment in the business. This figure is adjusted annually to reflect the partnership’s performance and the partner’s financial interactions with it. Tracking basis is important because it determines the tax consequences of distributions and the gain or loss when a partner sells their interest.

A partner’s initial basis is the sum of any cash contributed plus the adjusted basis of any property contributed. For example, if a partner contributes $20,000 in cash and equipment with an adjusted basis of $30,000, their initial outside basis is $50,000.

Each year, a partner’s basis is increased by their share of partnership income and any additional capital contributions. Basis is also increased by the partner’s share of any increase in partnership liabilities, which is treated as an additional cash contribution.

Conversely, a partner’s basis is decreased by their share of partnership losses and any distributions of cash or property received. Basis is also reduced by the partner’s share of any decrease in partnership liabilities. A partner’s basis can never be reduced below zero.

For example, consider a partner who starts the year with a basis of $50,000. During the year, their share of partnership income is $40,000, and they receive a cash distribution of $15,000. Their basis at the end of the year is calculated as: $50,000 (starting basis) + $40,000 (income) – $15,000 (distribution), resulting in an ending basis of $75,000.

A partner’s basis serves as a limit on the amount of partnership losses they can deduct. Any losses that exceed the partner’s basis are suspended and carried forward to future years. These losses can be deducted when the partner has sufficient basis to absorb them.

Tax Impact of Contributions and Distributions

When a partner contributes property to a partnership for an interest in it, neither the partner nor the partnership recognizes an immediate gain or loss. The partnership takes the property with the same basis that the contributing partner had in it. This rule allows partners to pool resources without triggering an immediate tax.

Cash distributions are tax-free to the partner as long as the amount does not exceed their adjusted basis in the partnership interest. The distribution is treated as a return of the partner’s investment.

If a partner receives a cash distribution greater than their basis, the excess amount is treated as a taxable gain, which is usually a capital gain. For example, if a partner with a $5,000 basis receives an $8,000 cash distribution, the first $5,000 is a tax-free return of capital that reduces their basis to zero. The remaining $3,000 is taxed as a capital gain.

Distributions of property other than cash also follow a non-taxable framework. When a partner receives a property distribution, they do not recognize a gain or loss. The partner takes the property with a basis equal to the partnership’s basis in that property.

Sale or Disposition of a Partnership Interest

When a partner sells their interest, the transaction is treated as the sale of a capital asset, and any resulting gain or loss is generally capital. The gain or loss is the difference between the amount realized and the partner’s adjusted basis. The amount realized includes cash, property received, and the selling partner’s share of partnership liabilities assumed by the buyer.

A complication arises from rules designed to prevent converting ordinary income into a more favorably taxed capital gain. This involves the concept of “hot assets,” defined under Internal Revenue Code Section 751.

Hot assets consist of the partnership’s unrealized receivables and inventory items. Unrealized receivables are rights to payment for goods or services not yet included in income, while inventory is property held for sale.

If a partnership holds hot assets when a partner sells their interest, a portion of the gain must be recharacterized as ordinary income. This amount is the gain attributable to the partner’s share of these assets. The remaining portion of the gain is treated as a capital gain.

For example, if a partner sells their interest for a total gain of $100,000, and their share of the gain from the partnership’s inventory is $30,000, that amount is reported as ordinary income. The remaining $70,000 of the gain is reported as a capital gain.