If you’re a partner in a business, you may have come across a situation that gave you pause. In a given year, your tax returns may show that you owe more on partnership income than was distributed to you from the partnership in which you’re a partner. Why is this? The answer lies partnership taxation.
Unlike regular corporations, a partnership business structure is not subject to income tax. Instead, each partner is taxed on the partnership’s earnings — whether or not they’re distributed. Similarly, if a partnership has a loss, the loss is passed through to the partners. (However, various rules may prevent a partner from currently using his share of a partnership’s loss to offset other income.)
While a partnership isn’t subject to income tax, it’s treated as a separate entity for purposes of determining its income, gains, losses, deductions and credits. This makes it possible to pass through to partners their share of these items. Learn more about a pass through partnership.
A partnership must file an information return, which is IRS Form 1065. On Schedule K of Form 1065, the partnership separately identifies income, deductions, credits and other items. This is so that each partner can properly treat items that are subject to limits or other rules that could affect their correct treatment at the partner’s level. Examples of such items include capital gains and losses, interest expense on investment debts and charitable contributions. Each partner gets a Schedule K-1 showing his or her share of partnership items.
Basis and distribution rules ensure that partners aren’t taxed twice. A partner’s initial basis in his partnership interest increases by his share of partnership taxable income. The determination of a partnership interest varies, depending on how the interest was acquired. When that income is paid out to partners in cash, they aren’t taxed on the cash if they have sufficient basis. Instead, partners just reduce their basis by the amount of the distribution. If a cash distribution exceeds a partner’s basis, then the excess is taxed to the partner as a gain, which often is a capital gain.
Two individuals each contribute $10,000 to form a partnership. The partnership has $80,000 of taxable income in the first year, during which it makes no cash distributions to the two partners. Each of them reports $40,000 of taxable income from the partnership as shown on their K-1s. Each has a starting basis of $10,000, which increases by $40,000 to $50,000. In the second year, the partnership breaks even (has zero taxable income) and distributes $40,000 to each of the two partners. The distribution of cash to each partner is tax-free. Each of them, however, must reduce the basis in his partnership interest from $50,000 to $10,000.
The example and details above are an overview and, therefore, don’t cover all the rules of partnership taxation. For example, many other events require basis adjustments and there are a host of special rules covering non-cash distributions, distributions of securities, liquidating distributions and other matters.