Is a Partnership a Pass-Through Entity for Tax Purposes?

Choosing the right business structure has significant tax implications, and partnerships are a common choice for those looking to share ownership without the complexity of a corporation. One key reason many opt for a partnership is its tax treatment, which differs from that of corporations in important ways.

Pass-Through Taxation

Unlike corporations, which are taxed as separate legal entities, partnerships do not pay federal income tax at the business level. Instead, income, deductions, and credits pass through to individual partners, who report their share on their personal tax returns. The amount each partner reports is based on their ownership percentage or as specified in the partnership agreement.

This structure avoids the double taxation corporations face, where profits are taxed at the corporate level and again when distributed as dividends. Instead, partners are taxed once, at their individual income tax rates. For example, if a partnership earns $200,000 in taxable income and has two equal partners, each would report $100,000 on their personal return. The tax owed depends on their individual tax bracket, which in 2024 ranges from 10% to 37%.

General partners are considered self-employed and must pay both the employer and employee portions of Social Security and Medicare taxes, totaling 15.3% on net earnings up to the annual threshold. Limited partners, however, are generally exempt from self-employment tax on their share of the partnership’s income unless they receive guaranteed payments for services rendered.

Forming a Partnership for Tax Purposes

Choosing the right partnership structure is essential, as each type has different legal and tax implications. General partnerships involve all partners sharing management responsibilities and personal liability for debts. Limited partnerships (LPs) require at least one general partner with unlimited liability and one or more limited partners whose liability is restricted to their investment. Limited liability partnerships (LLPs), often used by law and accounting firms, provide liability protection to all partners, shielding them from business debts and malpractice claims of other partners.

A partnership agreement is highly recommended. This document outlines ownership percentages, profit distribution, decision-making authority, and procedures for resolving disputes or dissolving the business. Without a written agreement, state default rules apply, which may not align with the partners’ intentions.

Partnerships must obtain an Employer Identification Number (EIN) from the IRS, even if they do not have employees, as it is required for tax filings and opening business bank accounts. Registration requirements vary by state, with LLPs typically required to file registration documents and pay annual fees. Some states also impose franchise or gross receipts taxes on partnerships, adding to compliance costs.

Allocating Income and Losses

Income and losses are typically distributed based on ownership percentages, but the IRS allows flexibility as long as allocations have “substantial economic effect” under Section 704(b) of the Internal Revenue Code. If an allocation lacks economic substance and is designed solely to minimize tax liabilities, the IRS can reallocate income and losses to reflect actual economic interests.

Special allocations are common when partners contribute different amounts of capital or bring unique expertise to the business. For example, if one partner provides 70% of the initial capital while another contributes 30%, they may agree that 70% of profits will go to the first partner until their investment is recovered, after which distributions shift to an equal split. These arrangements must be carefully documented to ensure compliance with tax regulations and to avoid disputes.

Loss allocations have additional restrictions. Partners can only deduct losses up to their “at-risk” amount under Section 465 and their basis in the partnership under Section 704(d). If a partner’s share of losses exceeds these limits, the excess is suspended and carried forward until they have sufficient basis to deduct it. Partners who personally guarantee partnership loans may increase their basis, allowing them to claim larger deductions. However, nonrecourse debt—where no individual partner is personally liable—typically does not increase a partner’s at-risk amount, except in certain real estate partnerships where special rules apply.

Reporting Obligations for Partners

Each partner must report their share of income, deductions, and credits based on the partnership’s annual tax filing. The partnership files Form 1065, U.S. Return of Partnership Income, which details the entity’s financial activity but does not calculate tax liability. Instead, it generates a Schedule K-1 for each partner, outlining their specific share of taxable items. These figures must be transferred to the individual partner’s tax return on Schedule E of Form 1040. Any discrepancies between the K-1 and what is reported can trigger an IRS inquiry, making accuracy critical.

Partners with foreign financial interests may have additional reporting obligations. If the partnership has foreign operations or investments, partners may need to file Form 8865 for foreign partnerships or Form 8938 under the Foreign Account Tax Compliance Act (FATCA) if their aggregate foreign assets exceed reporting thresholds. Noncompliance can result in penalties, with non-filing penalties for Form 8865 starting at $10,000 per occurrence.

State-Level Tax Aspects

While partnerships benefit from pass-through taxation at the federal level, state tax treatment varies. Some states conform closely to federal rules, while others impose additional taxes or filing requirements.

Certain states impose entity-level taxes on partnerships. California, for example, requires an $800 minimum franchise tax and an additional fee based on gross receipts for partnerships earning over $250,000. Tennessee and Texas levy franchise or margin taxes that apply regardless of pass-through status. In contrast, states like Florida and Nevada do not impose additional taxes on partnerships beyond personal income tax obligations for individual partners.

Partnerships operating in multiple states may also face apportionment rules, where income is divided among states based on factors like sales, payroll, or property. This can lead to tax liabilities in multiple jurisdictions, requiring careful tracking of income sources and compliance with varying state regulations.