Here is a super simple guide to understanding how partnerships are taxed. Quickly learn the basics of partnership taxation so you can better communicate with your tax professional and/or lawyer. This guide also features links to more advanced partnership concepts.
Disclaimer: The information presented on this website is only a basic introduction to s corporation and partnership taxes. We strongly recommend that you hire a professional to help you. The information provided here does not replace the IRS instructions for filing taxes. Incorrect filings could lead to large tax bills and penalties. Please hire a CPA or an EA to prepare and file your tax returns.
Partnership taxes – quick summary
Are you looking to go into business with others? If so, a partnership might be the best bet for your business.
A partnership is when one or more individual, corporation, or other entity create an arrangement to operate in business together.
The most popular type of partnership is generally created by forming a limited liability company (or other similar entity) with more than one member.
When there are multiple members of an entity other than a trust or corporation, the entity typically is taxed as a partnership (by default) unless it officially elects otherwise.
For example: a plumber, a drywall repair man, and water damage extractor wish to form a business together specializing in fixing homes after damage is caused to a home due to a pipe failure. If they wish to form a partnership, they can organize each as a member of one Limited Liability Company. They now have a partnership and they can contribute capital and labor – and split the profits – as agreed upon.
It’s pretty much as simple as it sounds, but there are some things to know about how a partnership is taxed.
Partnerships must file their own income tax returns and any net income or losses will “pass-through” to each partner according to their agreed upon share. Since the income passes through to each partner, the partnership itself usually does not pay any federal income tax.
When the partnership tax return is prepared, a form (called Schedule K1) is created and must be provided to each partner. The K1 explains to each partner how to report any proceeds (or losses) from the partnership on their personal tax returns.
I will expand on the taxation of partnerships with more detail later in the guide.
Partnership taxes – guide to the multi-member limited liability company (MMLLC)
Entity formation is not an IRS-governed part of business law. Instead, entity rules are created and provided by each state. The federal tax code, however, dictates how the entity will be taxed for federal tax purposes.
In most states, a “limited liability company” (or LLC) is the most common type of entity for a small business.
When an LLC has only one member, the federal taxation defaults to being totally disregarded for tax purposes, and thus the single member LLC, unless it elects otherwise, is taxed as a sole proprietorship.
The term “disregarded entity” sounds like it would be something bad, but a new small business that forms as a single member LLC can enjoy the financial and liability benefits of having the entity, but does not have to deal with complex or expensive tax reporting. Generally this is a good way to start.
But if two or more people are members of the LLC, the entity can no longer be “disregarded for tax purposes”.
Unless the multi-member LLC officially elects otherwise, they way it is taxed defaults to a “partnership”. Partnerships must file form 1065 (that’s the form number for a partnership tax return) each year on the federal level. There may also be state income tax filing requirements depending on the state in which the entity is formed and also the state(s) in which the entity does business or operates.
Note that there are exceptions to how LLCs are taxed, but that’s how it works in most cases.
Partnership income taxes
Partnerships in general, do not pay income tax on their profits.
Instead, they generally pass through income and expense items to their partners according to share.
For example, 3 partners have agreed to share the profits of a partnership as follows:
- Partner #1: 80% share of profits and losses
- Partner #2: 10% share of profits and losses
- Partner #3: 10% share of profits and losses
If the partnership earns $80,000 in net profit from business activities, each partner will end up reporting income on their personal tax return accordingly:
- Partner #1 will show $64,000 as income on their personal tax return, flowing through from the partnership
- Partners #2 and 3 will each show $8,000 as income on their personal tax return, flowing through from the partnership
Partnership income tax filing requirements
Each year, partnerships must file form 1065 “US Return of Partnership Income”, found here (opens in a new tab).
There may also be a state income tax filing requirement as well as other reports, registration, license, sales tax, use tax, and possibly additional required filings not mentioned.
Preparing and filing form 1065 with the required Schedule K1s is complex. We recommend that you hire an EA, CPA or attorney to prepare this form for you.
Income (or losses) from partnerships may have different characteristics that are taxed in different ways
Income from self employment is treated differently than long term capital gains. Rental income is also treated differently. There are several ways in which different income and expense types are treated for individual income tax purposes.
With a partnership, income that passes through to it’s partners maintains it’s “character”.
This is done using Schedule K1. Schedule K1 is prepared and filed along with the partnership tax return. One copy is filed with the IRS, and they are required to be distributed to each partner.
The K1, shown below, shows some of the boxes of different income and expense types. Look at boxes 1 through 11, for example. Most of these types of income are treated differently or taxed at different rates on the partner’s personal tax return.
Income (or losses) from partnerships may or may not be subject to self employment tax, depending on the type of income and the level of participation by the partner
First of all, please note that “income tax” is different from “self employment tax”.
They are totally different taxes. Self employment tax is pretty much the social security and medicare – just like you pay when you earn wages.
According to the IRS, partners that provide more than minimum services are considered “active” and “participating” and are known as general partners.
General partners are considered to be self employed for tax purposes and not as an employee of the partnership. All ordinary income and guaranteed payments from the partnership to general partners are subject to self employment tax.
Partners that are not active are considered “limited” partners. Limited partners do not pay self employment tax on ordinary partnership profits, but they are required to pay it on “guaranteed payments for services” provided to the partnership.
The IRS and the tax court are very strict when it comes to assigning who is a general partner, who is a limited partner, and whether excess payments beyond guaranteed payments are subject to self employment tax.
Please seek the advice of a professional before taking a position on this because choosing incorrectly can lead to a nasty tax bill with interest and penalties if audited.
Partnership tax return due dates and extensions to file
Important tip: Partnership tax return due dates are not on the same day as the individual tax return due dates.
According to the IRS instructions, a domestic partnership must file by the 15th day of the third month following the date that it tax year ended as shown on the tax return.
For typical and standard calendar year-filing partnerships, this will be the 15th of March.
Be VERY careful with the deadlines for partnership tax returns, as stiff penalties are imposed for late filings.
Note also that if the due date falls on a weekend or holiday, this might extend the deadline slightly.
Extensions can be filed using form 7004, but filers must realize that while an extension give time for a partnership to file its form 1065, each partner must estimate and pay in any expected tax liability by the 15th of April (in most cases). An extension does not allow extra time for the partners to “PAY” any tax balance. It’s only an extension to “FILE”.
Failure to file penalties for late partnership tax returns
Even though partnerships do not generally pay any tax, the IRS is very serious about form 1065 filing deadlines. This is because the K1s need to be filed with the IRS and distributed to the partners.
The IRS requires a report (for their database) of how much income each partner is supposed to report on their personal tax returns. The partners themselves also need this info to accurately file and pay any taxes on income that passed through to them from the partnership.
Penalties for non-compliance are huge, starting at $195 per partner, per month of being late. These is typically capped at 12 months per tax return.
The IRS may provide relief from these penalties, on a case by case basis, depending on whether the partnership had reasonable cause not to file, the delinquency was a one time and first time event, the partners have a plan to file on time for the future, and/or the late filing did not result in any late taxes being paid by the individual partners.