*Updated for 2024
If you’re in a business partnership, it’s important to understand how partnership taxes work.
What parts of your partnership income are taxed? How does partnership income differ from a corporation, limited liability company (LLC), or sole proprietorship? What’s that K-1 your CPA asks for every tax season?
This is your guide to commonly asked partnership income tax questions.
How are partnerships taxed?
Partnerships are pass-through businesses. This means the partnership’s income “passes through” to the partners’ personal income tax returns. This treatment differs from corporations, which pay income tax on corporate profits directly. Corporate shareholders also pay taxes on any profits distributed as dividends.
While operating as a partnership is one of the easiest business structures for businesses owned by two or more people, there is a downside. Partners pay income and self-employment taxes on all business profits, whether they reinvest those profits in the business or distribute them to the partners. Partners pay taxes on this income at their personal tax return rates (12% to 37%). They also pay self-employment tax—12.4% for Social Security taxes and 2.9% for Medicare taxes, for a combined 15.3% rate.
Fortunately, some partnership owners can claim the Qualified Business Income (QBI) deduction, which allows them to deduct up to 20% of their business income.
Sole proprietorships, LLCs and S corporations are also pass-through business entities, although how those entities file taxes differs.
How to file taxes for a partnership
While partnerships don’t pay federal income taxes directly, they do have to file a separate partnership tax return using an informational return, Form 1065.
Once the partnership return is complete, the business issues a Schedule K-1 to each partner. This schedule is used to report the partner’s share of the business’s profits and losses. You’ll need the information on that form to file your individual tax return using Form 1040.
Form 1065 is due on March 15th for calendar-year partnerships or the 15th day of the third month after the end of the partnership’s fiscal year. Form 1040 is due April 15 or the following business day if that date falls on a weekend or holiday.
If you need more time, you can request an automatic six-month extension.
How do partners get paid?
Partners in a partnership generally get paid two ways, depending on the partnership agreement. The most common way to get paid is through a distribution of profits, which is a payment from the business to the partners. These payments generally aren’t taxable to the partner, nor are they deductible expenses for the business.
Another way to get paid is through guaranteed payments. A partner can receive a guaranteed payment in return for their time invested, services provided, or capital made available to the partnership. Unlike distributions, these payments are taxable income to the partner. They’re also subject to self-employment taxes.
Guaranteed payments benefit the business, as they’re deductible as a business expense. However, because guaranteed payments reduce the amount of qualified business income passed through to the partners, it also reduces their QBI deduction.
It’s sometimes possible to reduce or not pay a guaranteed payment to increase QBI benefits. However, if the partnership agreement calls for guaranteed payments, the agreement needs to be amended by the due date of the partnership return (not including extensions). Still, amending the partnership agreement doesn’t guarantee that the IRS won’t scrutinize the change. The partnership should have a good business reason for the change. Otherwise, the IRS may recharacterize the payments.
Other items to address in the partnership agreement
Having a well-written partnership agreement in place is crucial. This document spells out the terms of the partnership, helps avoid partner disagreements, and is one of the first things an IRS auditor will ask for.
One important area to address in the partnership agreement is how to handle unreimbursed partnership expenses. Partners can incur a variety of unreimbursed costs while running the business. These can include items like travel, meals, gifts, dues to professional societies, and advertising costs. Addressing these expenses in the partnership agreement helps ensure that partners are treated fairly and that everyone knows who is responsible for what costs.
Partners can deduct unreimbursed business-related expenses on their Schedule E—the same form of their personal income tax return in which they report their share of partnership income. However, to be eligible to deduct these expenses, the unreimbursed expenses must be the kind the partner is expected to pay out of their own pocket (according to the partnership agreement).
Partners cannot deduct expenses they could have turned into the partnership for reimbursement.
How are profits distributed in a partnership?
How your business profits are distributed in a partnership is another area that should be spelled out in writing in the partnership agreement. That distribution agreement doesn’t have to be 50/50. While most partnerships allocate profits and losses based on each partner’s ownership percentage, you can agree to special allocations.
For example, if one partner provided all of the startup capital for the business, your partnership agreement might stipulate that partner gets 75% of the business profits or losses in the first year. Just remember that each partner pays taxes on 100% of their allocated income, regardless of whether they take cash out of the business or reinvest it for business growth.
This is one benefit of structuring the business as a partnership versus an S corporation—S corps don’t allow special allocations.
If you’re considering forming a partnership or another business structure and want to know how it will impact your income taxes, please reach out! We’d love to help you decide on the right business entity for you.