If you are a partner in a business, you may encounter a situation that gives you pause. In any given year, you may have been taxed on more partnership income than was distributed to you. The cause of this difference lies in the way partnerships and partners are taxed.
Unlike regular corporations, partnerships are not subject to income tax. Instead, each partner is taxed on the earnings of the partnership — regardless of the distributions. Similarly, if a partnership has a loss, the loss is passed through to the partners. (The rules regarding the use and timing of losses are not addressed here.)
While a partnership is not subject to income tax, it is treated as a separate entity for the 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, which is IRS Form 1065, “U.S. Return of Partnership Income.” On this form, the partnership separately identifies income, deductions, credits, and other items at the entity level. From here, the individual items are reported to owners. This allows partners to properly treat items subject to limits or other rules at the partner level. Examples of items subject to special treatment 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 for the year just ended.
Basis and distribution rules ensure partners are not taxed twice. A partner’s initial basis in his or her partnership interest (which varies depending on how the interest was acquired) is increased by his or her share of partnership taxable income. When income is paid out to partners in cash, they are not taxed on the cash if they have sufficient basis. Instead, partners reduce their basis by the distribution amount. If a cash distribution exceeds a partner’s basis, then the excess is taxed to the partner as a gain.
The HoganTaylor Tax Practice
If you have any questions about the content of this publication, or if you would like more information about HoganTaylor's Tax practice, please email Tony Otto, Tax Practice Lead, at jotto@hogantaylor.com.
INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.
