The Taxation of a Limited Partnership

A limited partnership (LP) is a business structure with two classes of partners. General partners manage the business and have unlimited personal liability for its debts. Limited partners are passive investors who contribute capital, and their financial risk is confined to their investment.

The primary tax characteristic of an LP is its “pass-through” status, meaning the partnership itself does not pay federal income tax. Instead, profits and losses flow directly to the partners, who report them on their individual tax returns. This structure avoids the double taxation associated with corporations. The partnership agreement is a foundational document that outlines the roles and profit-sharing arrangements among the partners.

The Partnership’s Tax Reporting Obligations

A limited partnership’s primary tax obligation is to report its financial activities to the IRS and its partners by filing Form 1065, U.S. Return of Partnership Income. This form details the partnership’s total income, deductions, and credits to calculate its overall net income or loss. Since the LP is a pass-through entity, Form 1065 is an informational return, and no tax is paid with this filing.

From the information on Form 1065, the partnership prepares a Schedule K-1 for each partner. This document allocates a specific share of each financial item to the respective partner based on the terms of the partnership agreement. The K-1 ensures that each partner knows the precise amounts of income, loss, deductions, and credits to report on their personal tax returns.

A function of the Schedule K-1 is to detail “separately stated items.” The partnership must report these items individually because they may be subject to different tax rules and limitations on a partner’s personal return. Examples of separately stated items include:

• Net rental real estate income
• Interest income
• Capital gains and losses
• Charitable contributions
• Section 179 deductions

This separate reporting is necessary for proper tax calculation at the individual level. For instance, a partner’s ability to deduct charitable contributions is subject to limitations based on their adjusted gross income. The character of the income is also preserved, so if the partnership earns long-term capital gains, it is reported as such on the K-1 and taxed at preferential rates on the partner’s return.

Taxation of Individual Partners

The items of income, gain, loss, and deduction reported on the Schedule K-1 are transferred to the partner’s personal tax return, Form 1040. Net income or loss from the partnership’s business activities is reported on Schedule E, Supplemental Income and Loss. Other separately stated items, like capital gains, are carried to the corresponding schedules of Form 1040.

While partners are taxed on their share of the partnership’s income, their ability to deduct any allocated losses is not automatic and is subject to several limitations. The first is the partner’s tax basis, which represents their economic investment in the partnership.

A partner’s initial basis is the amount of cash and the adjusted basis of any property they contributed. This basis increases by the partner’s share of taxable income and any additional contributions. A partner’s basis is decreased by their share of partnership losses and any distributions of cash or property they receive. A partner cannot deduct losses that are greater than their adjusted tax basis.

Beyond the tax basis limitation, partners must also contend with the at-risk rules. These rules further limit loss deductions to the amount a partner is personally considered “at risk” of losing. The at-risk amount includes the cash and property contributed and certain debts for which the partner is personally liable.

A difference between basis and at-risk amounts often involves nonrecourse debt, which is debt secured by partnership property but for which no partner is personally liable. While nonrecourse debt can sometimes increase a partner’s basis, it does not increase their at-risk amount. Any losses disallowed by either the basis or at-risk rules are suspended and carried forward to future years, where they can be deducted if the partner’s basis or at-risk amount increases.

Differentiating General and Limited Partner Tax Treatment

The tax treatment of income from an LP can differ depending on whether an individual is a general or a limited partner. These differences primarily revolve around self-employment taxes and the application of passive activity loss rules.

For a general partner, their share of the partnership’s ordinary business income is considered self-employment income. Because general partners are actively involved in managing the business, this income is subject to both Social Security and Medicare taxes, known as SECA taxes. Guaranteed payments received by a general partner for services rendered are also treated as self-employment income.

The treatment of a limited partner’s income is more complex. While the tax code provides an exception from self-employment tax for limited partners, the IRS focuses on the partner’s actual role rather than their formal title. If a partner designated as “limited” materially participates in the partnership’s business, the IRS may treat their share of income as subject to self-employment tax.

The passive nature of a limited partner’s involvement brings the Passive Activity Loss (PAL) rules into play. Because a limited partner’s activity is almost always defined as passive, any losses generated by the partnership are considered passive losses on their return. Passive losses can only be used to offset passive income from other sources, such as other limited partnerships or rental real estate activities.

Passive losses cannot be used to reduce active income, such as wages, or portfolio income, which includes interest and dividends. If a limited partner has no passive income in a given year, any passive losses from the LP are suspended. These suspended losses are carried forward indefinitely and can be used to offset passive income in future years or be fully deducted in the year the partner disposes of their entire interest in the partnership.

Tax Impact of Financial Transactions

Beyond the annual flow-through of income and losses, specific financial transactions within a limited partnership have distinct tax consequences. The two most common events are receiving distributions from the partnership and selling a partnership interest.

When a partnership makes a distribution of cash or property to a partner, the tax impact is tied to the partner’s basis. Distributions are treated as a tax-free return of capital, meaning they are not immediately taxable and reduce the partner’s adjusted basis in their interest.

Tax consequences arise only when a cash distribution exceeds the partner’s adjusted basis. Any amount of cash distributed in excess of the partner’s basis is treated as a capital gain. This rule allows partners to receive the economic benefit of their investment’s earnings without immediate taxation, up to the limit of their basis.

The sale of a partnership interest to another party is a taxable event that results in a capital gain or loss. The gain or loss is calculated by subtracting the partner’s adjusted basis in the interest from the amount realized from the sale. While this gain is usually capital in nature, a provision can recharacterize a portion of it as ordinary income.

This complication arises from “hot assets,” which primarily consist of the partnership’s unrealized receivables and inventory items. If a partnership holds these assets, any portion of the selling partner’s gain attributable to their share of these items must be taxed at ordinary income rates. This rule prevents partners from converting what would be ordinary income at the partnership level into a capital gain by selling their interest.