When it comes to taxes, surprises are rarely welcome, especially when you find out you’re being taxed more than expected. One group that this may happen to is business partners. If you’re a partner in a business, you might discover that you’ve been taxed more on partnership income than was distributed to you.

If this has happened to you, you’re probably wondering why. Let’s take a look at how and why this happens.

How partnerships and partners are taxed

Partnerships aren’t like regular corporations, which are subject to income tax. Partnerships, instead, have each partner member taxed on the partnership’s earnings regardless of whether they’re distributed to them. If there’s a loss, that loss is also passed through to the partners. 

(Note, though, that rules may limit a partner from using their part of a partnership’s loss to compensate for other income.)

Separate entities

As stated above, a partnership isn’t subject to income tax. Instead, it’s handled as a separate entity to determine its income, gains, losses, deductions, and credits. Handling it in this manner allows shares of said income, gains, losses, deductions, and credits to pass through to partners.

When it comes to filing, partnerships must file what’s known as an information return (IRS Form 1065). As part of Schedule K of this form, the partnership separately lists income, deductions, credits, and other items. 

Why? This makes it so partners can appropriately address items that are subject to limits or other rules that could impact their treatment at the partner’s level. Examples of these items include:

• Capital gains and losses
• Interest expense on investment debts
• Charitable contributions

Each partner receives a Schedule K-1 that shows their share of any partnership items.

Rules surrounding basis and distribution ensure that partners won’t be taxed twice. The partner’s initial basis in their partnership interest is increased by their share of partnership taxable income. Determination of this depends on how the interest was acquired.

When that income is received as a cash payout, they aren’t taxed on the cash if they have a sufficient basis. Instead, their basis is decreased through the amount of the distribution. If a cash distribution tops a partner’s basis, any excess will be taxed as a gain, often as a capital gain.

Here’s an example

Let’s say that two individuals contribute $10,000 each in order to start a partnership. In the first year, that partnership has $80,000 of taxable income and makes no cash distributions to the partners. Each partner reports $40,000 of taxable income from the partnership on their K-1s. 

Their starting basis is each $10,000, which increases to $40,000 to $50,000. In the second year, they break even with zero taxable income and each member has $40,000 distributed to each of them. Their cash distribution is received tax-free but each of them is required to reduce the basis in their partnership interest from $50,000 to $10,000.

Other rules and limitations

As with all tax situations, there are nuances and complexities. The example above doesn’t touch on all the rules or requirements. Other events may require adjustments of basis and there are many rules that cover noncash distributions, distributions of securities, liquidating distributions, and other matters. To learn more about how taxes for partnerships work, contact Smolin-Lupin today to learn more.