How Are Partnerships Taxed? Step-By-Step Guide

Partnerships are not subject to income tax at the entity level. Instead, they operate as pass-through entities, meaning the partnership’s income, deductions and credits flow directly to the individual partners. Each partner then reports their share of the partnership’s income or loss on their personal tax return. 

A financial advisor can help partners structure their tax obligations efficiently and plan for estimated tax payments to avoid unexpected liabilities.

Understanding How Partnerships Work

Partnerships are common business structures where two or more individuals come together to operate a business and share its profits and losses. This collaborative arrangement allows partners to pool their resources, skills and expertise to achieve common business goals. Each partner typically contributes something of value—whether it’s capital, labor or a specific skillset—and in return, they share in the business’s financial outcomes. 

Partnerships can vary in formality, ranging from informal agreements to legally binding contracts. But, they all require a mutual understanding and agreement on how the business will be run. There are several types of partnerships, each with its own legal and operational implications. The most common forms include: 

• General partnerships: In a general partnership, all partners share equal responsibility for managing the business and are personally liable for its debts.
• Limited partnerships (LPs): Limited partnerships consist of both general and limited partners, where the latter have limited liability and typically do not participate in day-to-day management.
• Limited liability partnerships (LLPs): LLPs offer a hybrid structure, providing partners with limited liability protection while allowing them to be involved in management.
• Multi-member LLCs: These are taxed as partnerships by default, meaning profits and losses pass through to the members’ personal tax returns.

How Partnerships Are Taxed

Partnerships themselves are not subject to federal income tax. Instead, they operate as pass-through entities, meaning that the profits and losses of the partnership are passed directly to the individual partners. Each partner then reports their share of the partnership’s income or loss on their personal tax return.

The allocation of income, deductions and credits among partners is typically outlined in the partnership agreement. This agreement dictates how each partner’s share of the profits and losses is determined. It’s important to note that these allocations must have substantial economic effect, meaning they should reflect the partners’ economic arrangement and not be solely for tax benefits. 

Partners are taxed on their share of the partnership’s income, regardless of whether they receive any distributions. This can sometimes lead to a situation known as “phantom income,” where partners owe taxes on income they haven’t yet received as cash in hand.

General partners in a partnership are generally considered self-employed, which has specific tax implications. They are responsible for paying self-employment taxes on their share of the partnership’s income, which covers Social Security and Medicare taxes. This is an important consideration for partners, as these taxes can significantly impact their overall tax liability. 

Additionally, all partners may need to make estimated tax payments throughout the year to cover their anticipated tax obligations.

How Profits Are Distributed in Partnerships

Profit distribution in partnerships depends on several factors, with capital contributions being a key consideration. Partners who invest more money into the business often receive a larger share of the profits.

The time and effort each partner contributes can also impact how profits are divided. Those who take on greater responsibilities or play a more active role in operations may be entitled to a higher percentage.

Skills and expertise are another factor in determining profit shares. A partner with specialized knowledge or experience that benefits the business may receive a larger portion.

Each partner is taxed on their share of the profits, which must be reported on their personal tax returns. Proper tax planning is essential to manage liabilities effectively.

How to File Partnership Taxes

Filing partnership taxes may seem complicated, but knowing the steps can make it easier. Here are four simple steps to help you through the process:

1. Gather necessary financial documents. Collect all relevant financial documents, including income statements, balance sheets and records of expenses. Accurate documentation can help you comply with IRS regulations.
2. Complete IRS Form 1065. Partnerships must file IRS Form 1065, the U.S. Return of Partnership Income. This form reports the partnership’s income, deductions and credits along with other information. While the partnership itself doesn’t pay taxes, this form is important for informational purposes.
3. Prepare Schedule K-1 for each partner. Each partner receives a Schedule K-1, which details their share of the partnership’s income, deductions and credits. Partners use this information to report their share on their personal tax returns.
4. Meet filing deadlines: Partnership tax returns are typically due on March 15th for calendar-year partnerships. Filing on time helps avoid penalties and offers partners the necessary information to file their personal returns.

Bottom Line

Partnerships do not pay federal income tax, as their income, deductions, and credits pass directly to the partners. Each partner is responsible for reporting their share of the partnership’s profits or losses on their personal tax return. This structure allows the business’s financial activity to be taxed at the individual level rather than at the entity level.

Tax Planning for Businesses

• A financial advisor can help you as a partner understand your tax obligations, optimize deductions and develop strategies to manage tax liabilities. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Owning a business comes with a greater level of responsibility, including paying business taxes. This guide breaks down your general tax responsibilities, deductions and credits.

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