How Are Limited Partnerships Taxed? Federal Tax Treatment
Explore how federal tax liability flows from a limited partnership to its members, and how a partner's specific role impacts their individual tax outcome.
A limited partnership is a business structure combining different levels of partner involvement. It consists of at least one general partner, who manages the business and has unlimited personal liability for its debts. In contrast, limited partners are passive investors who contribute capital but do not participate in management; their liability is restricted to their investment.
This structure is used for ventures like real estate or investment funds. The roles are distinct, as a limited partner who becomes actively involved in management risks losing their limited liability status. The federal tax treatment of a limited partnership is a key characteristic that sets it apart from other entities.
The Pass-Through Taxation Model
A primary feature of a limited partnership is its status as a pass-through entity for federal tax purposes, meaning the partnership itself does not pay income tax. Instead, financial results—including income, deductions, and losses—flow through to the individual partners. Each partner reports their allocated share on their personal tax returns, regardless of whether they received a cash distribution.
This model contrasts with C corporations, which are subject to “double taxation.” A C corporation pays corporate income tax on its profits, and when those profits are distributed as dividends, shareholders pay personal income tax on that same income. The pass-through system avoids this entity-level tax, so profits are taxed only once.
To facilitate this, the partnership files an informational return, Form 1065. From this return, the partnership generates a Schedule K-1 for each partner. This schedule breaks down each partner’s specific share of income and other tax items needed for their personal tax filings.
Partnership-Level Tax Filings
The partnership’s core annual tax obligation is filing Form 1065, U.S. Return of Partnership Income. This informational return provides the IRS with an overview of the partnership’s financial operations. It reports the entity’s gross income, deductible expenses, ordinary business income or loss, and other separately stated items.
Filing Form 1065 is a mandatory annual requirement. The due date for a partnership following a calendar year is the 15th day of the third month after its tax year ends. If this date falls on a weekend or legal holiday, the deadline moves to the next business day; for the 2024 tax year, the deadline is March 17, 2025.
After calculating its total income and deductions on Form 1065, the partnership allocates these amounts among the partners according to the partnership agreement. It then creates a Schedule K-1 for each partner, sending a copy to the partner and filing all copies with the IRS.
Partner-Level Tax Responsibilities
Each partner uses their Schedule K-1 to report the specified amounts on their personal tax return, Form 1040. Information like ordinary business income is transferred to Schedule E, Supplemental Income and Loss. This income is taxed at the partner’s individual rate and is due whether or not the partner received any cash from the partnership.
A significant tax distinction exists between general and limited partners regarding self-employment taxes. A general partner’s share of ordinary business income is considered self-employment income and is subject to Social Security and Medicare taxes, reported on Schedule SE.
Conversely, income allocated to a limited partner is considered passive and is not subject to self-employment tax. This passive designation means that any losses passed through are subject to passive activity loss rules. These rules prevent a partner from deducting passive losses against other income, like wages; instead, losses are carried forward to offset future passive income. Because partnership income is not subject to automatic withholding, partners are required to make estimated tax payments.
Understanding Partner Basis and Distributions
A partner’s basis represents their economic investment in the entity. The initial basis is the amount of cash and the adjusted basis of property the partner contributes. This basis is adjusted annually, increasing with additional contributions and the partner’s share of income, and decreasing by distributions and the partner’s share of losses.
Partners must track their basis, as it limits the amount of partnership losses they can deduct. A partner cannot deduct losses that exceed their adjusted basis. Disallowed losses are suspended and can be carried forward to be used in future years when the partner has sufficient basis.
It is important to distinguish between a partner’s allocated income and a distribution. An allocation of income on Schedule K-1 is a taxable event, while a distribution of cash or property is treated as a tax-free return of the partner’s investment. Distributions are not taxable unless the cash distributed exceeds the partner’s adjusted basis, in which case the excess is treated as a capital gain.