Partnership taxation can be puzzling. You may be taxed on more partnership income than was distributed to you in a given year. Why does this happen? It’s due to the way partnerships, and partners are taxed. Unlike C 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 is passed through to the partners. (However, various rules may prevent a partner from using his or her share of a partnership’s loss to offset other income.)
Pass Through Your Share
While a partnership isn’t subject to income tax, it’s treated as a separate entity to determine its income, gains, losses, deductions, and credits. This makes it possible to pass through to partners their share of these items.
An information return must be filed by a partnership. 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 their partnership interest (the determination of which varies depending on how the interest was acquired) is increased by their share of taxable partnership 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 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.
An Example of How This Works:
Two people 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 is increased 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 cash distributed to them is received tax-free. After that, however, they each must reduce the basis in their partnership interest from $50,000 to $10,000.
More Rules and Limits
The example and details above are an overview and don’t cover all the rules. For example, many other events require basis adjustments, and there are a host of special rules covering noncash distributions, distributions of securities, liquidating distributions, and other matters. Contact us if you’d like to discuss partnership taxation.