When Are Partners Taxed on Retained Partnership Earnings?

A common point of confusion for business owners is the tax treatment of partnership earnings. New partners often question what happens when the business earns a profit but retains the cash for future needs instead of distributing it. For tax purposes, a partnership is a business relationship between two or more people who join to carry on a trade or business. The structure’s tax implications differ significantly from a corporation, leading to misunderstandings about when partners are taxed on company income.

The Pass-Through Principle of Partnership Taxation

A partnership is a “pass-through” entity, meaning the business itself does not pay federal income tax. Instead, all profits, losses, deductions, and credits flow through to the individual partners. Partners must pay tax on their share of the partnership’s income in the year the business earns it. This tax liability exists regardless of whether the partnership distributes the cash or retains it for operational needs, such as buying inventory.

The partnership must file an annual informational return, Form 1065, U.S. Return of Partnership Income, with the IRS. This form details the partnership’s total income and expenses for the year. While the partnership pays no tax with this return, it serves as the basis for determining each partner’s tax obligation. From Form 1065, the partnership prepares a Schedule K-1 for each partner.

The Schedule K-1 breaks down each partner’s specific portion of the business’s financial results. It reports the partner’s distributive share of various income types, such as ordinary business income and interest, as well as any deductions or credits. The amounts on the Schedule K-1 are determined by the partnership agreement, which outlines how profits and losses are allocated.

Each partner uses their Schedule K-1 to complete their personal income tax return, Form 1040. The income from the K-1 is added to the partner’s other personal income and taxed at their individual rate. For example, if a two-partner partnership with a 50/50 profit-sharing agreement earns $100,000 and retains it all, each partner receives a Schedule K-1 showing $50,000 in income. Each must then report and pay tax on that $50,000, even though they received no cash from the business.

Calculating and Adjusting a Partner’s Basis

A partner’s basis is their tax-defined investment in the partnership, and it is a dynamic figure that changes over the life of the business. This calculation is important for tracking the tax consequences of partnership activities. The initial basis is established by the amount of cash and the adjusted basis of any property the partner contributes at formation. This starting value is the foundation for all subsequent adjustments.

A partner’s basis increases for several reasons. When the partnership earns a profit, each partner’s distributive share of that income increases their basis, regardless of whether the income is distributed or retained. This adjustment accounts for the tax a partner has already paid on those earnings. A partner’s basis also increases if they make additional capital contributions or if the partnership earns tax-exempt income.

Conversely, a partner’s basis decreases due to certain events. A partner’s basis is reduced by any distributions of cash or property they receive from the partnership. A partner’s share of any partnership losses or non-deductible expenses also causes a reduction in basis.

For instance, if a partner starts with a $10,000 basis and their share of the partnership’s retained earnings is $25,000, their basis increases to $35,000. The partner pays tax on the $25,000 in the year it was earned. This basis increase reflects the taxed, undistributed profit, ensuring it is not taxed a second time when eventually paid out.

Tax Consequences of Partnership Distributions

After a partner has paid tax on their share of retained earnings and adjusted their basis, the eventual distribution of that cash has its own tax rules. Generally, a cash distribution is treated as a tax-free return of capital. This is because the partner was already taxed on the income when the partnership earned it. The distribution itself is not a taxable event, provided it does not exceed the partner’s adjusted basis.

Each cash distribution a partner receives reduces their adjusted basis. For example, consider a partner with an adjusted basis of $35,000. If the partnership distributes $10,000 of cash to the partner, they receive the money tax-free. Their adjusted basis is then reduced by the distribution, leaving a new basis of $25,000.

An exception to this tax-free treatment occurs when cash distributions exceed a partner’s adjusted basis. If a partner receives a cash distribution greater than their basis, the excess amount is treated as a taxable capital gain. This gain must be reported on the partner’s personal tax return.

To illustrate, if a partner with a $25,000 basis receives a $30,000 cash distribution, the first $25,000 is a tax-free return of capital that reduces their basis to zero. The remaining $5,000 is treated as a capital gain. The character of the gain, whether short-term or long-term, depends on how long the partner has held their partnership interest.

Distinguishing Guaranteed Payments

It is important to distinguish profit distributions from guaranteed payments. These payments are made to a partner for services rendered or for the use of capital. The defining characteristic of a guaranteed payment is that it is calculated without regard to the partnership’s income. For example, a partner might receive a fixed monthly payment for managing the business, regardless of profitability.

Guaranteed payments are treated as ordinary income to the receiving partner and are reported on their Schedule K-1. For the partnership, these payments are treated as a business expense and are deductible from its ordinary income, similar to salaries paid to non-partner employees.

This treatment contrasts with a distributive share of profits, which is not deductible by the partnership. For the partner, a profit distribution is a tax-free return of capital up to their basis. Guaranteed payments, on the other hand, are always taxable as ordinary income to the partner in the year they are received or accrued.