- Find out more about the taxes on partnership earnings and losses.
- Learn why the IRS treats partnerships as separate entities.
- Discover which form partnerships must file and what information they must include.
- Find out how a partner’s basis affects their taxation.
- Discover more rules that affect the taxation of partnerships.
Partners in business may come across a tax situation that gives them pause. In a given year, you may pay taxes on more partnership income than you had distributed to you from the partnership in which you’re a partner.
Why did this happen? The answer lies in the taxation of partnerships and partners. Unlike regular corporations, partnerships aren’t 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 passes 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.)
Partnerships are separate entities. What does that mean for partners?
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.
A partnership must file an information return, IRS Form 1065. On Schedule K of Form 1065, the partnership separately identifies income, deductions, credits, and other items. They do this so that each partner can properly treat items 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 do not get taxed twice. A partner’s initial basis in his partnership interest (the determination of which varies depending on how the interest was acquired) increases by his share of partnership taxable income. When that income is paid out to partners in cash, they aren’t taxed on the cash if they have a 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.
Here’s an example
Two individuals each contribute $10,000 to form a partnership. The partnership has $80,000 of taxable income in the first year. During this time, 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. They receive the cash distributed to them tax-free. Each of them, however, must reduce the basis in his partnership interest from $50,000 to $10,000.
Other rules and limitations
The example and details above are an overview and, therefore, don’t cover all the rules. 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. Have questions about your partnership and its associated taxes? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations. Ready to book an appointment now? Click here. Know someone who might need our services? We love referrals!
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