How Are Partnerships Taxed?

By default, a business with two or more owners is called a partnership. Like a sole proprietorship, partnerships are not legal entities and don’t require a state filing to get started.

Most partnerships form through agreements that outline how the partners will split profits and liabilities. You can further formalize a partnership by becoming a limited liability partnership (LLP), which turns your business into a legal entity that shields owners’ personal assets from business debts.

Partnerships are pass-through entities, where partners report and pay income taxes based on their portion of partnership income. For example, if you and I run a partnership where we split profits evenly, I’d be responsible for paying tax on half of the business’s income through our personal tax returns.

Unlike C corporations, partnerships don’t pay an entity-level tax. Though partnerships pay no business income taxes, they file information return Form 1065 each year to relay income and deductions information to the IRS.

Partnership taxation isn’t reserved for partnerships. Limited liability companies (LLCs) may elect partnership taxation, among other options.

How to file partnership taxes

Follow these four steps to file your partnership taxes.

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1. Draft annual financial statements

Before you embark on filing your business partnership taxes, prepare the three basic financial statements: balance sheet, income statement, and statement of cash flow. The information in these financial statements provides a basis for your tax software or tax professional to complete the filing.

Those who use accounting software should get through this step more quickly than those who keep their books by hand.

2. File partnership information return Form 1065

Partnerships report revenue and business tax deductions on Form 1065. Though partnerships don’t pay income tax at the company level, the IRS still wants to see what the business is up to. Form 1065 is called an “information return” because the IRS doesn’t expect an income tax payment attached to the filing.

Partnerships file information return Form 1065 to report business income, deductions, and credits. Image source: Author

Line 22 on Form 1065 shows a partnership’s ordinary income or loss. Partners split up and report their share of income or loss on their personal income tax returns. A partnership agreement delineates how profits and losses are shared among partners.

Form 1065 will prompt you to file a plethora of tax forms to report more specifically about business operations, from depreciation to the cost of goods sold. Tax software will walk you through it, but you’ll want to have your financial statements and accounting software open during the process.

3. Issue Schedules K-1 to each partner

A Schedule K-1 is like an employee’s Form W-2. Partnerships issue a Schedule K-1 to each partner to decree each partner’s share of business profits or losses. Partnerships report any taxable earnings a partner received during the year on a partner’s K-1.

The two sections you’ll spend the most time filling in are guaranteed payments (lines 4a through 4c) and the partner’s share of profits (line 1). We’ve talked a bit about the latter, so let’s dive deeper into the former.

A guaranteed payment is the closest thing to a salary for a partner. Guaranteed payments promise a partner a specific amount of compensation regardless of company performance.

Absent a guaranteed payment arrangement, a partner’s income relies solely on his or her share of business earnings, which leaves too much to chance in some companies. Guaranteed payments are taxed as ordinary income to the partner and are a deductible business expense to the partnership.

Most partnerships pay their partners through a mix of guaranteed payments and a share of business profits. Image source: Author

The K-1 not only provides information about a partner’s taxable income, but it also gives the IRS an update on the partner’s capital account, which is essentially the value of a partner’s stake in the business. A partner’s share of company debts is also listed on the K-1.

If you’re filling out Schedule K-1 without tax software, make sure you download the Schedule K-1 that corresponds to Form 1065. You don’t want to be halfway through the form and suddenly realize you downloaded Schedule K-1 for S corporation shareholders.

4. File your individual return

You’ve gotten to step four without paying income taxes on your partnership income. With the Schedule K-1 your partnership provided in hand, you’re ready to file your personal taxes.

Partnership income -- whether it came as a guaranteed payment or as a share of your business’s profits -- is taxed at your individual tax rate. Business partners also pay 15.3% of their earnings in self-employment taxes. File Schedule SE to calculate self-employment taxes.

Limited partners in a limited partnership (LP) -- which differs from an LLP -- don’t pay self-employment taxes on their share of partnership profits. If you don’t know whether this applies to you, it probably doesn’t.

Partner with tax software on your partnership taxes

Using self-employment tax software will undoubtedly cut down on time spent filing your partnership taxes and could help you identify deductions and credits you didn’t know about.