Income Taxation on Partnerships

Partnership Taxation

Unlike most business entities, such as C or S corporations, a partnership[1] is never subject to federal income taxation. Rather, the partners themselves are liable for the income tax on the partnership’s taxable income,[2] with each partner individually taking into account his distributive share of each item of partnership income, gain, deduction, loss, and credit.[3] This makes the partnership a pure “pass-through” entity, with all of its taxable income and loss passing through and being taxed to its owners.

Despite its never being subjected to income tax, a partnership must still account for its own gross income, deductions, etc., by reporting these items annually[4] on Form 1065, U.S. Return of Partnership Income. Each partner’s distributive share of these tax items is then reported to the partners (and the Internal Revenue Service) on Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. The partners, in turn, recognize their respective shares of these K-1 items on their own returns.

Separately Stating Partnership Tax Items

Section 702(a) of the Code lists several items of taxable income and deduction that a partnership must “separately state” from its bottom-line taxable income when reporting its income and loss each year. This is because each of these items may be recognized in different ways by the partners. Partners who are individuals, for example, will apply the preferential (generally 15% or 20%) rate on long-term capital gains he or she recognizes,[5] whereas partners who are corporations pay the same rate on capital gains it does on trade or business profits.[6] Similarly, both individual and corporate taxpayers may reduce their taxable capital gains by capital losses recognized during the year, thus the partnership’s capital gains must be separately stated from its ordinary income in order for the partners to properly apply those rules.

Consider, for example, a partnership with two partners, one an individual and the other a corporation. During a given taxable year, the partnerships recognizes a $100 capital gain, receives $100 in dividends on the stock of a corporation it owns, and recognizes an $800 profit on a trade or business activity in which the partnership engages. Overall the partnership has recognized $1,000 in taxable income for the year, but it still must report each of these items separately to its partners.

If the $100 capital gain the partnership recognizes is long-term capital gain then the individual partner will be entitled to apply the preferential capital gains rate on his or her distributive share of that gain. Similarly, if the $100 in dividends are “qualified dividends,” then the individual partner may also be entitled to use the preferential rate of section 1(h) on his or her distributive share of those dividends. On the other hand, the $800 in trade or business income may be considered “net earnings from self-employment” for the individual partner. For the individual partner this kind of income is subject not only to an income tax under section 1 of the Code but may also be subject to the self-employment tax imposed by section 1401.

For the corporate partner, there is no separate rate of tax on ordinary income and capital gain. Nevertheless, the corporate partner may be entitled to apply some capital losses it recognizes from other sources against its distributive share of the partnership’s capital gain, reducing the amount of gross income the corporate partner recognizes overall for the tax year. Moreover, the corporate partner may be entitled to the “dividends received deduction” of section 243 of the Code, thus stating separately the corporate partner’s distributive share of the dividends the partnership received will enable the corporate partner to properly apply that rule.

Separately stating each item of partnership income, deduction, gain, loss, and credit is therefore necessary in order for the partners to properly recognize their respective distributive shares. Since it is the partners, and not the partnership, that pays tax on a partnership’s income, each partner must know his or her share of each different kind of tax item the partnership might recognize during a tax year.

Determining the Character of Partnership Tax Items

Another implication of the separately stated item rule is that the character of each partnership-level tax item must be maintained as it passes through to the partners. The “character” of a tax item refers to its specific nature under the Internal Revenue Code. That is to say, a particular item of income or loss can be “ordinary” or it can be “capital.” Trade or business income is generally an ordinary item of income, whereas the profit on the sale or exchange of a piece of property is generally a capital gain. Certain other items may have an even more specific character. Transfers of cash or property to a qualifying charitable organization may be considered a “charitable contribution,” for example, which characteristic must be maintained as that deduction is passed through to the partners in order for them to properly account for it on their own returns.[7]

Although a partnership is not a “taxpayer” in the sense that it pays an income tax on its earnings, it nevertheless must compute its gross income, its deductions, and its gains and losses as if it were before passing those items through to its partners. Under section 703(a) of the Code, a partnership makes these computations “in the same manner as in the case of an individual,” meaning that whenever the tax law imposes a different rule on the characterization of a tax item for an individual taxpayer than it does for a corporate taxpayer, the partnership uses the individual taxpayer rule.

Take, for example, the rule for losses at section 165 of the Code. The general rule is that every taxpayer, whether an individual or a corporation, is entitled to a deduction for losses sustained during a tax year.[8] Subsection (c) of section 165, however, provides that a taxpayer who is an individual may only deduct trade or business losses, investment losses, and casualty losses. While a partnership is neither an individual nor a corporate taxpayer per se, section 703(a) requires that it apply section 165 as if it were an individual. A partnership, therefore, must apply the deductible loss limitation of section 165(c) when computing its tax items for any given year, and is thus only entitled to deductions for trade or business losses, investment losses, and casualty losses.

A similar example is found in section 166, the provision for the deduction of losses from bad debts. While a corporate taxpayer which sustains a bad debt loss during a tax year is generally entitled to an ordinary deduction for that loss, an individual taxpayer who sustains a “nonbusiness” bad debt loss must characterize the loss as a short-term capital loss.[9] As partnerships must always use the rules for “individual” taxpayers they will be required to apply the latter bad debt rule when characterizing a bad debt loss.

Each Partner’s “Distributive Share” of Partnership Tax Items

Probably the most attractive aspect of partnerships to taxpayers is the rule of distributive shares. Under section 704(a) of the Code, a “partner’s distributive share of income, gain, loss, deduction, or credit shall…be determined by the partnership agreement.” This means that while 100% of a partnership’s tax items must be passed through to its partners in one way or another, each partner’s respective share of those items is determined by them, or more specifically by whatever agreement, whether written or oral, that they have made amongst themselves. This makes partnerships very flexible in terms of planning for the allocation of tax items among the partners.

Consider the partnership discussed above with $100 in capital gain, $100 in dividends, and $800 in trade or business income. The two partners—one an individual and the other a corporation—are by no means required to divide those tax items evenly between them. Rather, each partner’s distributive share of each of those tax items will be determined by the partners’ agreement. They might agree, for example, that the individual partner will be allocated 60% of the capital gain, 70% of the dividends, and 80% of the trade or business income, with the remainder of each item allocable to the corporate partner. There is no requirement that this be accomplished by way of percentages, either. They might instead agree, for example, that the individual partner will be allocated the first $75 of each of these items, whatever the amount might be each year, with the whole of any remainder being allocated to the corporate partner. Note too that the partners’ respective proportions of partnership capital are irrelevant to the determination of their distributive shares. In each of the allocation schemes described above it does not matter whether the partnership’s capital was funded evenly by the two partners or even whether one partner contributed all of the partnership’s operating capital. The only factor for determining the partners’ distributive shares is their agreement.

There are limitations on this flexible allocation rule, of course. Principal among these limitations is the “substantial economic effect” rule of section 704(b). This rule is incredibly complex and is far beyond the scope of this presentation. Generally, however, the partners’ agreement as to the determination of their respective distributive shares will be respected (must be respected, in fact) by the taxing authorities only insofar as the particular allocation has a real and substantive effect on the partner. If, for example, the allocation to a partner of an item of depreciation deduction does not affect the amount of capital the partner would be entitled to if the partnership were dissolved, then the allocation does not have “economic effect” to that partner and need not be taken into account by the taxing authorities. In such a case, the partners’ distributive shares would be re-determined in such a way that they did have economic effect. In the case of the two-member partnership described above, this does not necessarily mean a 50-50 allocation, nor does it necessarily mean an allocation in proportion to the partners’ shares of capital. It means only that the partners’ agreement as to that particular allocation must be adjusted, maybe even very slightly, until it complies with the substantial economic effect rule.

Footnotes