Partnership Distribution vs. Dividend: How Are They Taxed?
The tax treatment of payments from your business is determined by its legal structure. Explore the core differences between partnership and corporate payouts.
Business owners receive payments from their companies, but the tax implications of these payments are dictated by the business’s legal structure. The method for taxing a distribution from a partnership is different from that of a dividend paid by a corporation. Understanding these distinctions is important for comprehending personal tax obligations and the financial reporting of the enterprise.
The Taxation of Partnership Distributions
A partnership operates as a pass-through entity for tax purposes. The partnership itself does not pay income tax; its profits and losses are “passed through” to the individual partners. Each partner reports their share of the partnership’s income on their personal tax return and pays the resulting tax, regardless of whether they receive a cash distribution.
The taxation of a partner’s distributions is governed by “basis,” which represents their economic investment in the partnership. It begins with the initial capital contributed and is adjusted each year. The basis increases by the partner’s share of the partnership’s income and decreases by any distributions they receive.
Cash distributions from a partnership are generally treated as a tax-free return of capital. When a partner receives a cash payment, it is not immediately taxable; instead, the distribution reduces the partner’s basis. For example, if a partner has a basis of $50,000 and receives a $10,000 cash distribution, their basis is reduced to $40,000, and no tax is owed on that payment.
A distribution becomes a taxable event only when the cash received exceeds the partner’s basis. If a distribution is larger than the partner’s existing basis, the excess amount is treated as a capital gain. For instance, if a partner with a $5,000 basis receives a $12,000 distribution, the first $5,000 is a tax-free return of capital that reduces their basis to zero. The remaining $7,000 is taxed as a capital gain.
The Taxation of Corporate Dividends
Unlike a partnership, a C corporation is a distinct legal and taxable entity separate from its owners. The corporation pays income tax on its profits at the corporate level. When the corporation distributes its after-tax profits to shareholders, those payments, known as dividends, are taxed again at the individual shareholder level. This two-tiered system is referred to as “double taxation.”
A distribution from a corporation is classified as a dividend only to the extent that it is paid from the corporation’s “Earnings and Profits” (E&P). E&P is a tax accounting measurement of a corporation’s economic ability to pay dividends. If a corporation with a positive E&P balance makes a distribution, it is treated as a taxable dividend to the shareholders.
Dividends are categorized as either “qualified” or “non-qualified” (ordinary), which determines the tax rate. Qualified dividends are taxed at lower, long-term capital gains rates. To be considered qualified, the dividend must be paid by a U.S. or qualifying foreign corporation, and the shareholder must meet a minimum holding period for the stock. Dividends that do not meet these requirements are non-qualified and are taxed at the shareholder’s regular ordinary income tax rates.
If a corporation makes a distribution that exceeds its current and accumulated E&P, the excess portion is not a taxable dividend. It is treated as a non-taxable return of capital, which reduces the shareholder’s basis in their stock. Should distributions exceed both E&P and the shareholder’s stock basis, any further amount is taxed as a capital gain.
Tax Reporting and Documentation
For partners in a partnership, the primary document is Schedule K-1 (Form 1065). This form details the partner’s share of the partnership’s income, deductions, and credits. Distributions are reported on this schedule, but the partner is responsible for tracking their own basis to determine if any portion of a distribution is taxable.
The income reported on Schedule K-1 flows to Schedule E of the partner’s personal Form 1040. If a distribution exceeds the partner’s basis, the resulting capital gain is reported on Schedule D.
Shareholders of a C corporation receive a Form 1099-DIV from the corporation for distributions of $10 or more. This form breaks down the total distribution, indicating how much is classified as ordinary dividends and how much qualifies for lower capital gains rates.
The amounts from Form 1099-DIV are reported on the shareholder’s Form 1040. Ordinary dividends are reported on Schedule B, while qualified dividends are used to calculate the tax at preferential rates. Any capital gains from distributions in excess of basis are reported on Schedule D.