A partnership is a legal entity composed of two or more persons who join together to carry on a trade or business and who agree to split the profits or losses. Typically, partners begin by contributing money or property and labor or skills to the business. A partner can be an individual person, corporation, trust, estate, or another partnership.
How Are Partnerships Taxed?
Pass-Through Entity
Like an S corporation, a partnership is a conduit or pass-through entity. The partnership business does not pay a tax on income. Rather, the business passes items of income, loss, deduction, and credit through to the partners, who report the items and calculate the tax on their individual Form 1040 returns. Nevertheless, a partnership must keep accurate track of income and expenses, like any business. However, certain publicly traded partnerships are treated as C corporations for tax purposes.
Annual Informational Tax Returns Required
Partnerships must also file annual informational tax returns, showing the business’s income and expenses, on Form 1065. This form is due on the 15th day of the 4th month after the end of the partnership tax year—usually April 15. Every year, partnerships must also issue Schedule K-1 to the IRS and to each partner. This form shows each partner’s distributive share of profits, losses, credits, and deductions. Partners use the K-1 information to complete Schedule E, which passes a net income or loss figure to page one of Individual Form 1040.
It is important to note that partners are taxed on their distributive share of partnership items regardless of whether these items are actually distributed to the partners.
Example(s): David and Derek’s equal partnership makes a $70,000 profit, but they only take $30,000 each out of the partnership that year, leaving $10,000 in the bank as working capital. For tax purposes, they are each taxed on a distributive share of $35,000.
How Is Taxable Income Determined?
Business Income
Business income from a partnership is generally computed in the same manner as income for an individual. That is, taxable income is determined by subtracting allowable deductions from gross income. This net income is passed through as ordinary income to the partner on Schedule K-1.
Other Income
Other items of partnership income (such as interest, dividends, capital gains, net rental income or loss, and deductions for charitable contributions) must be “separately stated.” This is because these items could affect the tax liability of different partners depending on their particular tax situations. These items, computed separately from business income, are also passed through to the partner on Schedule K-1.
A partner will report his or her share of ordinary partnership income on Schedule E of Form 1040. Separately stated items of income or loss are reported on the appropriate forms or schedules. For example, capital gains shown on the partner’s Schedule K-1 are reported on Schedule D of the partner’s Form 1040.
How Are Items Allocated to Partners?
A partner’s distributive share of any item of income, gain, loss, deduction, or credit is generally determined by the partnership agreement. The distributive share is usually the same as the partner’s percentage of ownership in the partnership. However, the partnership agreement can allocate income, gain, loss, deductions, or credits to individual partners in a different manner provided the allocation method has “substantial economic effect.”
An allocation generally has substantial economic effect if both of the following apply:
- There is a reasonable possibility that the allocation will substantially affect the dollar amount of the partners’ shares of partnership income or loss, independently of tax consequences
- The partner to whom an allocation is made actually receives the economic benefit or bears the economic burden corresponding to that allocation
For more information, contact an accountant or tax attorney.
How Is a Partner’s Basis Affected by Pass-Through Items?
Unlike a C corporation, where the basis of stock remains constant unless additional shares are purchased or sold, basis in a partnership will increase or decrease frequently. A partner’s basis is important in determining the amount of losses and deductions that can be passed through to the partner. A partner’s basis is increased by:
- Cash and property contributed by him or her
- Any taxable gains the partner recognizes on the transfer of property to the partnership
- Separately and nonseparately stated items of income, including capital gains
- Liabilities the partner assumes and increases in partnership liabilities
A partner’s basis is decreased by:
- Separately and nonseparately stated items of loss and deduction
- Nondeductible partnership expenses
- Cash withdrawals
- Liabilities of the partner that the partnership assumes
- Adjusted basis of partnership property distributed to the partner
Example(s): Jen and Melissa each have an initial $10,000 basis in their partnership and agree to split all profits and losses 50-50. At the end of the first year, the partnership has an overall loss of $20,000. Jen and Melissa will each be assigned $10,000 of this loss, reducing each partner’s basis to zero.
A decrease in a partner’s share of partnership liabilities is treated as a distribution of money by the partnership, which decreases the partner’s basis in his or her partnership interest (but not below zero). When a partner’s basis has been reduced to zero, further reduction of the partner’s share of partnership liabilities will result in taxable gain to the partner.
How Are Losses Treated?
Losses Passed Through to Partners
Losses are passed through to the partners. These losses may take the form of a business ordinary income loss for the year or a capital loss on the sale of property during the year. A partner’s distributive share of losses in a given year is limited to the amount of his or her actual investment in the business (i.e., the partner’s adjusted basis in the partnership). Basis generally includes the partner’s pro rata share of partnership liabilities.
Loss Carryover Allowed
Any disallowed loss or deduction may be carried over to subsequent years and may be used when the partner’s basis is increased through additional capital contributions or net income.
Example(s): Rob paid $5,000 for 50 percent of a partnership. In its first year of business, the partnership lost $14,000, which was reported on the partnership tax return. In addition, $7,000 (50 percent) of this amount was also reported to Rob on Schedule K-1. Of this amount, Rob can currently claim only $5,000 as a loss, because this is the amount of his investment (basis) in the partnership. The remaining $2,000 can be carried over to future years to offset income in those years.
At-risk rules and passive loss rules place additional limitations on a partner’s ability to deduct losses passed through from the partnership. Contact your accountant, attorney, or financial planning professional for more detailed information. If you have questions or need assistance, contact the Experts at Henssler Financial:experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
