How Exactly Are General Partnerships Taxed?

A general partnership is a business structure where two or more individuals co-own a business and share in its profits and losses. For federal tax purposes, partnerships are “pass-through” entities, meaning the business itself does not pay income tax. Instead, the financial results, including profits, losses, deductions, and credits, flow directly to the individual partners.

Each partner reports their share of the business’s income or loss on their personal tax returns. This structure avoids the double taxation that can occur with other business entities. The allocation of profits and losses among the partners is defined in a partnership agreement, which governs their financial relationship.

The Partnership’s Informational Tax Return

Although a partnership does not pay its own income tax, it has an annual filing requirement with the IRS. The business must file Form 1065, U.S. Return of Partnership Income. This informational return provides the IRS with a detailed overview of the partnership’s financial activities for the tax year. The deadline for filing Form 1065 is March 15th for calendar-year partnerships.

Completing Form 1065 involves reporting all the partnership’s financial data, including total gross receipts or sales. The partnership subtracts the cost of goods sold and all its deductible operating expenses from this income. Deductions include employee wages, rent, business supplies, and utility payments. The result is the partnership’s ordinary business income or loss for the year.

From the completed Form 1065, the partnership prepares a separate Schedule K-1 for each partner. This document breaks down the partnership’s overall financial figures and allocates a portion to each partner based on the partnership agreement. For example, if a two-person partnership with a 50/50 profit-sharing agreement earned $100,000 in ordinary income, each partner’s Schedule K-1 would report $50,000 of that income.

The Schedule K-1 details the partner’s share of profits or losses and their portion of other financial items, like interest income, rental income, and charitable contributions. The partnership must send a copy of the Schedule K-1 to each partner. It also files all K-1s with the IRS, attached to the Form 1065.

How Individual Partners Report Income

Upon receiving their Schedule K-1, each partner reports their share of the partnership’s income or loss on their personal tax return, Form 1040. The amounts from the K-1 are transferred to Schedule E (Supplemental Income and Loss). This schedule consolidates income from sources like rental real estate, royalties, and pass-through entities. The net profit or loss from Schedule E then flows to the main Form 1040, affecting the partner’s total income.

A partner’s ability to deduct partnership losses is limited by their “partnership basis.” Basis is the partner’s economic investment in the business, including cash and property contributed, plus their share of partnership income, less any distributions received. A partner cannot deduct losses that exceed their basis.

Partners can receive money from the partnership in two primary ways: guaranteed payments and distributions. Guaranteed payments are made to partners for services or for the use of capital, without regard to the partnership’s income. These payments are taxable income to the partner and are deductible by the partnership as a business expense. For example, a partner managing daily operations might receive a $60,000 guaranteed payment, which is taxable to them even if the partnership was not profitable.

Distributions are withdrawals of cash or property from the partnership and are not immediately taxable. A distribution is treated as a return of the partner’s investment and reduces their partnership basis. For instance, if a partner with a basis of $50,000 receives a $10,000 cash distribution, their basis is reduced to $40,000, and the distribution is tax-free. Distributions become taxable as a capital gain only when they exceed the partner’s basis.

Understanding Self-Employment Tax

Partners in a general partnership are considered self-employed, not employees. Because of this, the partnership does not withhold Social Security and Medicare taxes from payments made to them. Instead, partners are personally responsible for paying these taxes through the self-employment tax, which applies to their net earnings from the partnership.

The self-employment tax is calculated on Schedule SE (Self-Employment Tax), filed with Form 1040. The tax rate is 15.3%, composed of 12.4% for Social Security up to an annual income limit and 2.9% for Medicare with no income limit. The tax is based on the ordinary business income and any guaranteed payments reported on the partner’s Schedule K-1.

A feature of this tax helps equalize the treatment between self-employed individuals and employees. Partners can deduct one-half of their self-employment tax when calculating their adjusted gross income (AGI) on Form 1040. This deduction acknowledges that employers pay half of an employee’s Social Security and Medicare taxes.

Paying Taxes Throughout the Year

Partners must pay their income and self-employment taxes throughout the year by making quarterly estimated tax payments to the IRS. These payments must cover the tax liability on the partner’s share of partnership income and any other income not subject to withholding. Failure to pay enough tax through this method can result in underpayment penalties.

The IRS provides several methods for submitting quarterly payments. Partners can pay online using IRS Direct Pay or the Electronic Federal Tax Payment System (EFTPS). Payments can also be made by check or money order through the mail using Form 1040-ES, Estimated Tax for Individuals.

These estimated tax payments are due in four installments. Partners are responsible for calculating their expected tax liability for the year to meet these deadlines:

• April 15
• June 15
• September 15
• January 15 of the following year