Taxes Made Simple

To put it as concisely as possible, partnership taxation works very much like sole proprietorship taxation, but with an extra step in the middle in which the profit (or loss) gets allocated to the partners.

Partnerships themselves are not actually subject to Federal income tax. Instead, they—like sole proprietorships—are pass-through entities. While the partnership itself is not taxed on its income, each of the partners will be taxed upon her share of the income from the partnership.

Form 1065

Form 1065 is the form used to calculate a partnership’s profit or loss. Filling out a Form 1065 is no more difficult than filling out a Schedule C for a sole proprietorship. On the first page, you simply list the revenues for the business, list the expenses for the business, and then subtract the total expenses from the total revenues. It’s exactly what you would expect.

On the second page of Form 1065 you answer several yes/no questions about the nature of the partnership. For instance, you’ll be asked whether any of the partners are not U.S. residents, whether the partnership had control of any financial accounts located outside of the U.S., and other questions of a similar nature.

Schedule K and Schedule K-1

The third page of Form 1065 is what’s known as Schedule K. Schedule K is used to break down the partnership’s income into different categories. For instance, ordinary business income goes on line 1, rental income goes on line 2, interest income shows up a little bit later on line 5, etc.

After filling out Schedule K, you’ll fill out a separate Schedule K-1 for each partner. On each partner’s Schedule K-1 is listed that partner’s share of each of the different types of income.

EXAMPLE: Aaron and Jake own and operate a partnership. Their partnership agreement states that they’re each entitled to exactly 50% of the partnership’s income. If, on Schedule K, the partnership shows ordinary business income of $50,000 and interest income of $200, each partner’s Schedule K-1 will reflect $25,000 of ordinary business income and $100 of interest income. This income will eventually show up on each partner’s regular income tax return (Form 1040).

What’s important to note here is that allocations from a partnership maintain their classification once they show up on the partners’ individual tax returns. This is important because the tax rate on some types of income/gain is different than the rate on other types. For instance, long-term capital gains (gains from the sale of investments that were held for greater than one year) are taxed at a maximum tax rate of 15%.

EXAMPLE: Aaron and Jake’s partnership buys shares of a stock, holds the shares for several years, and then sells them for a gain of $10,000. When Aaron’s $5,000 share of the gain shows up on his tax return, it still counts as a Long-Term Capital Gain (as opposed to counting as ordinary income). As such, it will only be taxed at 15%, even if Aaron is in the 25% tax bracket.

Self-Employment Tax for Partnerships

Ordinary business income from a partnership is generally subject to the Self-Employment Tax when it is passed through to the partners. This makes sense given the rule that we just discussed about income maintaining its classification when allocated to a partner on his or her K-1.

Allocated Profit vs. Distributed Profit

One thing that many owners of partnerships are surprised by when their first tax season rolls around is that partners get taxed on their allocated share of the profit, regardless of what was distributed to them. Don’t worry. It sounds complicated, but it’s really not that bad. This is something best explained with an example.

EXAMPLE: Michelle, Kayla, and Tim start a partnership. Their partnership agreement states that profit or loss will be evenly allocated to the partners.
In the first year, their partnership makes $60,000. However, they’re sure that their business could grow quickly if they had the capital. So, they decide not to distribute any cash to the partners. Instead, they make plans to use all $60,000 to buy new production equipment next year.

Despite the fact that none of the partners actually received any cash payout, they’re each going to be taxed on $20,000 of business income (1/3 of the $60,000 total). That is, each is taxed on his or her “allocated profit” of $20,000 rather than his or her “distributed profit” of $0.

[Note: Profits and losses in a partnership are not required to be split evenly between the partners. The partners can choose to split the profit or loss in any way they choose. It just makes the math in the examples easier if we give each partner an equal share.]

In Summary

• Like sole proprietorships, partnerships are “pass through” entities. A partnership is not subject to Federal income tax. Rather, its owners are subject to Federal income tax on their share of the profit.
• Form 1065 is used to calculate a partnership’s profit or loss.
• Schedule K and Schedule K-1 are used to show each partner’s allocated share of the profit/loss.
• Income (or gain) from a partnership maintains its original classification when it is passed through to a partner. As such, long-term capital gains will be taxed at a max rate of 15%, and ordinary business income is subject to Self-Employment Tax.
• Partners are taxed on their allocated share of the profit, regardless of how much of the profit is actually paid out to them.

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