Taxation of Partnerships

A partnership is 2 or more people or other entities who contribute money and property to start a business based on a partnership agreement (IRC §761).

A partnership — like an S corporation or a limited liability company — is a flow-through business entity where income, gains, losses, credits, and deductions flow to the individual partners. The partnership is not taxable, though it must file an informational tax return. Except for the members of limited liability companies and limited liability partnerships, each partner is personally liable for all partnership debts. However, certain organizations — listed in the instructions for Form 8832, Entity Classification Election, such as insurance companies, tax-exempt organizations, and even real estate investment trusts formed after 1996 — cannot be classified as a partnership for federal tax purposes.

Spouses who own a qualified entity in a community property state can be classified as a partnership by filing the appropriate forms, or the spouses can choose to be treated as a sole proprietorship by filing Schedule C, Profit or Loss from Business. A qualified entity is wholly owned by the spouses as community property, is not treated as a corporation, and no one other than the spouses has an ownership interest in the entity.

Although partnerships are governed by state law, the states have all adopted the Revised Uniform Partnership Act (RUPA), so there is some uniformity in the United States in how partnerships work.

Partnerships have some tax advantages over other business entities. For instance, income, loss allocations, and distributions must be proportional to the ownership interest of the shareholders of an S or C corporation, while a partnership may annually allocate income and cash flow among the partners that best suits the partners. Partnerships allow the pooling of resources, have simple filing requirements, avoid double taxation such as that on corporate profits, and is easy to discontinue. Partnerships can liquidate tax-free, whereas liquidating corporations are taxed at the entity level.

Limited partnerships are much like general partnerships except that a limited partnership has 1 or more general partners and 1 or more limited partners. General partners have full liability for all partnership debts, but the liability of limited partners is limited to their investment. In most states, limited partnerships must register with the Secretary of State or the Department of Corporations. If the limited partnership offers the public shares, then it must also register with the Securities and Exchange Commission. Family-owned businesses are often organized as family-limited partnerships with certain tax advantages, especially in estate planning.

Other types of partnerships that limit personal liability include limited liability companies (LLC) and limited liability partnerships (LLP), where even the general partners enjoy limited liability. They are not liable for any judgments against the other partners, and creditors only have access to the assets of the LLC or LLP — the individual partners have no liability for the debts other than their LLC or LLP interest. LLCs can have 1 member, while LLPs must have at least 2 members.

Under the 2017 Tax Cuts and Jobs Act, pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorships and independent contractors may deduct 20% of their business income. However, this deduction phases out for couples earning at least the lower threshold of the phaseout range (adjusted annually for inflation). The range for the 2024 tax year:

This new business deduction, called the §199A deduction or the deduction for qualified business income, equals the lesser of:

This deduction expires at the end of 2025.

The Legal Treatment of a Partnership

A partnership can be viewed as an aggregate of partners or a separate entity. As an aggregate (aka conduit), the partnership is treated as an aggregate of separate tax-paying partners, a channel through which income, deductions, credits, and other items flow to the partners (IRC §701), which they report on their individual returns. The partnership does not exist separately from the partners.

Partners and partnerships are treated as separate entities. For instance, both the partnership and the partners must file tax returns, and the partnership can choose a tax year that differs from the partners. So even though tax law often treats a partnership as a conduit, it also treats it as an entity.

Exclusion from Being Treated as a Partnership for Federal Tax Purposes

Certain partnerships not conducting a business can choose to be completely or partially excluded from being treated as a partnership for federal tax purposes if all partners agree to the choice and they can figure their taxes without knowing the other's income.

Aside from the joint venture as an option for spouses, the most common partnerships that can choose not to be treated as a partnership include investment partnerships, where the participants buy, manage, and sell investment property, but only if:

An operating agreement partnership can also be excluded from being treated as a partnership if:

An eligible organization can elect to be excluded from partnership tax requirements by indicating the desire in the partnership return for the 1st tax year for which the exclusion is desired, even if the filing date is extended.

Starting a Partnership

Partners can be individuals, trusts, estates, corporations, associations, or other partnerships. A partnership may also be classified as, or part of, a syndicate, group, pool, joint venture, or other unincorporated organization if the organization is not a corporation, trust, or estate. IRC §7701

A general partnership can be started by simple agreement — it does not even have to be a written agreement, although it should be since it will prevent many problems. Without a written contract, state law may determine any disputes.

When starting a partnership, initial decisions must be made to conduct the business, such as choosing methods of accounting and depreciation, whether to amortize startup costs, and choosing the tax year. Each partner contributes money, property, or services to the partnership, representing each partner's capital interest, measured by the capital sharing ratio, the partners' percentage ownership of the initial capital. The total capital of the partnership = the net asset value of the partnership, the value remaining after all partnership liabilities have been paid.

Because the partnership is not a taxable entity, another ratio that must be established is called the distributive share, or the profit interest, which determines the allocation of profits, losses, and other tax-related items to each partner. The distributive share is often proportional to the partner's capital interest, but the partnership agreement often provides for a different ratio because of differences in the hours worked by each partner and in the skills or connections they bring to the partnership. The distributive share can be changed by amending the partnership agreement. A partner may also have only a profit interest because they did not invest any capital, but their interest is earned by working for the partnership — these partners are often called profit partners.

The partnership agreement can also provide a special allocation of some separately stated items, such as the interest from tax-free investments. So, if a partner contributed tax-free municipal bonds to the partnership, the agreement could provide that the contributing partner receives all the interest from those bonds. However, special allocations must have some economic purpose other than altering tax liabilities for the partners. For instance, if a partnership earns tax-free interest and that interest is distributed preferentially to the partner in the highest tax bracket, then the IRS may reallocate the income according to the distributive share.

Many partnership tax items that flow through to the partners are separately stated items because different partners may have limits on what they can deduct. For instance, charity contributions may be limited by the adjusted gross income of the partner. Another example where the items are separately stated is ordinary income and capital gains or losses because they are taxed differently. Each partner may have other capital gains or losses that can be combined with the gains or losses from the partnership. Other items usually stated separately include dividend income, tax preferences and adjustments to the alternative minimum tax, any expenses that qualify for the foreign tax credit, and expenses that may qualify as itemized deductions for the partners. Section 179 expenses are also reported separately since what each partner can claim is limited. Deductible losses are limited by the partner's basis in the partnership; excess losses can only be deducted when the partner's basis increases.

What is not separately stated is netted out and divided among the partners according to their distributive share.

Partnership Capital Accounts

Partners can contribute money, assets, or services in exchange for their partnership interest. The total contribution determines each partner's percentage ownership of the partnership and is recorded in the partners' capital account, representing the equity of each partner in the partnership. The distributive shares of income accrue to the partners' capital account, and losses are deducted from it. The total equity of a partnership is determined like stockholders' equity for a corporation:

Assets = Liabilities + Partners' Tax Capital Accounts

Partners' Tax Capital Accounts = Assets − Liabilities

The capital account balance = the tax basis of the partnership interest, which will change annually when the partnership earns income or suffers losses, and from withdrawals by the partners. So if 50/50 partners have $20,000 in their capital account, and the partnership earns $30,000 for the year, then $15,000 is distributed equally to both partners unless otherwise specified. So, each partner will have $35,000 in their capital account. If a partner withdraws $10,000, he will have $25,000 in his capital account. However, the partners must pay taxes on their $15,000 share of income earned during the year, whether they withdraw it or not.

Any property contributed to the partnership increases the partner's interest by the property value. However, if the partner had debt on the property when it was transferred to the partnership, and the partnership assumes the liability, then the value of the property to the contributing partner = the property's fair market value + the portion of the liability that still applies to the contributing partner. So if a partner contributes land with a fair market value of $10,000 to a 50/50 partnership, where the contributing partner has a tax basis of $5000 and a mortgage of $4000 on the property, then the partner's capital interest is increased by the value of the contribution, which = $10,000 + 1/2 of the mortgage that the partner is still liable for, equaling a total of $12,000. No taxes are due on any gain until the property is sold or disposed of.

When a partner contributes services for a percentage of the profits, that amount is ordinary taxable income when the partner provided the services. This is common, since 1 partner often has the money while the other has the expertise and time to operate the business.

The assumption of a partnership liability by a partner is considered a contribution of capital in the amount of the liability.

However, if a person contributes services to receive a profits interest in the partnership, then the value of that interest is not taxable unless:

The capital accounts record the partners' tax basis in the partnership. Adjusting the basis prevents double taxation when the partners sell their interest in the partnership.

As a partnership operates, the partner’s basis will change during the partner’s ownership, either increasing or decreasing (IRC §754). The partner’s basis increases by:

A partner’s basis decreases by:

Partnership Tax Reporting

Partners must pay tax on partnership net income, even if the partnership retains the income. Any amount not withdrawn increases that partner's basis; distributions decrease it. Therefore, distributions to partners per se are not taxed unless the distribution exceeds the partner's adjusted basis in the partnership, in which case, the excess is taxable; otherwise, the draw is considered a nontaxable return of capital. See Partnership Distributions for more information.

As pass-through entities, profits and losses of the entity pass through to the owners. Nonetheless, the partnership must file a tax return, even if no tax is due.

A partnership must get a federal employer identification number (FEIN) from the IRS that uniquely identifies the partnership, just as a Social Security number uniquely identifies individuals. Most states also use this number, though some may issue their own ID.

For tax years after 2017, certain partnerships must have a tax matters partner (TMP), who must be a general partner. The TMP is designed to replace the partnership representative.

A partnership must file Form 1065, U. S. Return Of Partnership Income for each year of its operation. Form 1065 is much like Schedule C, which sole proprietors use to report income. The tax return is due on the 15th day of the 3rd month after the end of the partnership tax year. However, a partnership that only invests in property but does not operate as a business need not file Form 1065. A partnership can file Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns to request an automatic extension of 6 additional months to file a tax return. Most states tax partners but not partnerships. However, they do require filing a form like Form 1065. Partnerships also often pay a state franchise fee to operate in the state.

Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. is an informational form sent by the partnership to the IRS and to each partner, showing each partner's portion of the income or loss, deductions, credits, and other allocated items from the partnership. Partners report the business income or loss in Part II of Schedule E, Supplemental Income and Loss, and any interest or dividends are reported on Schedule B, Interest and Ordinary Dividends. Likewise, the partnership reports any capital gains or losses on Scheduled D, Capital Gains and Losses.

General partners, but not limited partners, must pay self-employment tax on their share of partnership profits. Partnerships with income must also pay estimated income taxes 4 times annually. For a calendar year partnership, the dates on which the estimated payments must be made are the same as those for sole proprietors: April 15, June 15, September 15, and January 15 of the next year. Form 1040-ES is used to report and pay estimated taxes. The federal payments cover both income and self-employment taxes. Estimated payments must also be made to the state.

If the partnership tax year differs from the partners, then the partners must include partnership income or losses for the full partnership fiscal year ending during the partner's tax year. So if a partnership's fiscal year ends on May 31, and the partners use a calendar tax year, then the partners must report the annual income of the partnership as of May 31 on their next tax return, even though 7 months of that income was earned in the previous year. However, tax rules restrict the choice of tax year for a partnership to prevent selecting a tax year for the primary purpose of deferring income.

Partnership expenses are deductible as they are for any other type of business if it is related to the trade or business that the partnership is engaged in. However, the expenses are shown on the partnership's tax return — Form 1065 — not on the individual partners' returns.

The IRS introduced new forms, Schedules K-2 and K-3, for pass-through entities and filers of Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships to standardize international tax reporting of international business activities or foreign partners for tax years 2021 and thereafter. Schedule K-2 reports partners’ distributive shares or S corporation shareholders’ pro-rata shares of international items as a whole, and Schedule K-3 reports each partner's or shareholder's share of these items. These schedules may still be necessary even if the business entity had no foreign source income if a partner or shareholder claims a credit for foreign taxes, though the IRS has provided some transition relief (Notice 2022-38) for good faith efforts to comply with these provisions.

Partnership Representative (PR)

For partnerships with more than 100 partners and for partnerships that do not opt out, the partnership must designate a Partnership Representative (PR) to represent the partnership before the IRS, especially for an audit. The PR, who need not be a partner, can be any person, entity, or even the partnership itself, and there can be no more than 1 PR. The PR must be designated on the partnership tax return for each taxable year. The PR must have a substantial presence in the United States, meaning that the entity or individual must have a US taxpayer identification number, US street address, telephone number with a US area code, and can meet with the IRS at a reasonable time and place, according to Treasury Regulation §301.7605-1.

Unlike the Tax Matters Partner (TMP), who often served as a liaison between the partnership and the IRS before 2018 and had limited authority to bind the partners, the partnership representative has the sole authority to act on behalf of the partnership during partnership audit procedures and can bind all the partners to any agreements between the PR and the IRS.

The partnership can opt out of using a PR annually by choosing the small partnership election if the partnership has no more than 100 partners. The partnership must notify each partner of the election, and the IRS must then audit and assess tax for each partner.

The PR can be designated, changed, or revoked by using Form 8979, Partnership Representative Revocation, Designation and Resignation, but this form must be submitted in prescribed ways, which can be found in the Instructions for Form 8979, Partnership Representative Revocation, Designation, and Resignation Form.

Tax on the Value of the Partnership Interest

Capital accounts must be adjusted to report the proper tax amount. Contributing additional cash or properties to the partnership increases the contributing partner's tax basis by the contribution amount. Capital accounts are not affected by partnership debts since if the partnership takes out a loan, the proceeds are considered an asset offset by the liability of the debt. When a partner contributes property, there may be a realized gain or loss on the property to the partnership. However, both gains and losses are deferred by IRC §721 until the partnership is liquidated, or the partner sells their partnership interest.

Partnerships are rarely audited because partnerships do not pay taxes directly — only the partners do. However, if the IRS does audit the partnership or any of the partners, all the partners will likely be audited.

Transferring or Terminating a Partnership Interest

Selling a partnership interest to another partner has no tax implications for the partnership. However, the selling partner will have a taxable gain or loss, determined by subtracting the selling partner's tax basis in the partnership from the sale proceeds of the partnership interest. If the partner held the partnership interest for longer than 1 year, the gain is subject to the long-term capital gains rate. However, gains or losses on unrealized receivables, which are expected payments for noncapital assets, including inventory and provided services, are ordinary income. The sale must be reported to the IRS on Form 8308, Report of the Sale or Exchange of Certain Partnership Interests, which is filed with the partnership tax return.

If the partnership itself buys a partner's interest, it is the same as selling to every partner in the partnership, which is referred to in the tax code as a retirement of the partner. For the retiring partner, the partner's capital interest is 1st subtracted from the proceeds to determine taxable income. If the partner's tax basis exceeds the sales proceeds, the partner can deduct it as a loss on their investment. If the retiring partner is relieved of any debt of the partnership, that portion of the debt is treated as income for the retiring partner.

If a partnership interest is sold before the end of the partnership's tax year, the retiring partner must pay ordinary income tax on their share of the profits earned during the current tax year until the date of the sale. Gain or loss on the partner's tax basis in the partnership is treated as a capital gain or loss.

A partnership automatically ends upon the death or withdrawal of a partner unless the partnership agreement provides otherwise. All partnership property is then considered distributed equally to all the partners, including the deceased or retiring partner. The partners will, therefore, have a gain or loss equal to the property value received minus the partners' tax basis in the partnership. A deceased partner's assets become part of his estate.

Terminating a Partnership

Under §1.708 - 1(b), a partnership terminates when no part of the business is continued by any partners. It will also be considered terminated if at least 50% of the interest in the partnership's capital and profits is sold or exchanged within 1 year, even if it is a sale or exchange to another partner. However, this last provision does not apply to partnerships elected to be a large partnership under the tax code. The termination date is when the business is completely stopped or when total sales or exchanges of a partnership interest within the last 12 months reaches at least 50%.

Often, the partnership will be terminated before the end of its tax year, resulting in a short tax year, when the end of that tax year is through to the date of termination. The return will be due on the 15th day of the 3rd month after termination.

Converting to a Limited Liability Company

Converting a partnership into an LLC does not terminate the partnership, the tax year does not close, and the LLC can continue to use the partnership taxpayer identification number. The only necessary adjustment is if the partnership had recourse debt that became nonrecourse debt. Then the partners' bases must be adjusted to the new sharing ratios. However, if a partner's share of liabilities decreases below the partner's basis, the amount exceeding the basis must be recognized as gain.

Historical Notes

Since 2017, the Surface Transportation and Veterans Healthcare Choice Improvement Act of 2015 has modified some business filing dates: