How Partnerships and Multi-Member LLCs Are Taxed

Does the partnership pay income tax itself?

A partnership generally passes its federal income or loss to its partners instead of paying federal income tax on that profit. A multi-member LLC treated as a partnership follows the same federal rule. Partners include their shares on their own returns, whether or not the business pays them cash (IRS: Form 1065 instructions).

Passing income through does not remove every tax obligation at the entity level. A partnership can owe employment taxes if it has employees, withholding on income allocated to foreign partners, or an amount assessed under the centralized partnership audit rules (IRS: Form 1065 instructions; IRS: audit rules).

An LLC's state-law label does not settle its federal tax classification. If you are deciding whether your LLC uses partnership or corporate tax rules, see How LLCs are taxed.

What does the partnership file, and what does each partner receive?

The partnership files one Form 1065 and prepares a Schedule K-1 for each partner. These report the business's results and each partner's share; Schedule K-2 and Schedule K-3 add international tax information when required (IRS: Publication 541; IRS: K-2/K-3 instructions).

The partnership must consider K-2 and K-3 even without foreign income or foreign partners. The IRS instructions describe domestic and small-partnership filing exceptions, each with partner notice and K-3 request rules. If your return needs international tax information, request K-3: a request received at least 1 month before Form 1065 is filed can trigger filing K-2 and K-3; a later request generally requires K-3 within 1 month. Check the instructions for the year being filed before relying on an exception.

For a calendar-year partnership, Form 1065 is generally due March 15 after year-end (IRS: Form 1065 instructions). See Which returns your business files for extensions and whether an inactive LLC must file; see late-filing penalties if a return was missed.

How is each partner's share decided, and is retained profit taxed?

Each partner reports the income, loss, deduction, and credit allocated to them under the partnership agreement, subject to tax rules. A partner can owe tax on an allocated profit even when the partnership retains all the cash (IRS: Form 1065 instructions).

The partnership generally does not withhold federal tax for U.S. individual partners, so a partner may need estimated tax payments even if the business distributes no cash.

The agreement may give partners different shares of different items. The tax split must generally match their real economic deal: a partner allocated an item must receive its benefit or bear its burden. An allocation made only to shift tax may be disregarded; then the partners' actual interests control (US Code: section 704; eCFR: allocation rules). A partner who contributes property with built-in gain or loss may also need a special allocation. Review the agreement and contribution records before preparing the K-1s.

How are guaranteed payments and distributions taxed?

A guaranteed payment is set without regard to partnership income and is generally ordinary income to the recipient. A cash distribution is generally a withdrawal of the partner's investment and reduces their basis; it is usually not taxed again unless the cash exceeds that basis (IRS: Publication 541).

Guaranteed payments are not wages and generally are not subject to employee wage withholding (IRS: Publication 541). Separate withholding can apply to a foreign partner; see Foreign partners and withholding. A debt reduction may be treated like a cash distribution. A payment tied to a partner's property contribution can instead be a taxable sale, and property distributions can trigger special rules (IRS: Publication 541). Some property distributions also require the partner to file Form 7217 (IRS: K-1 instructions). See Paying yourself from an LLC for choosing and recording owner payments, and health insurance for owners for premiums paid for partners.

Do partners and LLC members pay self-employment tax?

An individual general partner's share of trade or business earnings and guaranteed payments from that business, whether for services or capital, generally enter the self-employment tax calculation. A partner who qualifies for the limited-partner exception generally excludes their distributive share but includes guaranteed payments for services actually rendered (IRS: Form 1065 instructions; US Code: section 1402).

For a working limited partner or LLC member, review their services, management role, and economic interest before deciding whether the exception applies. In an August substitute opinion, the Fifth Circuit held that a limited partner plays no significant role in managing or running the business; it sent the case back for a factual decision (Fifth Circuit: *K Alain*). That case involved a limited partnership, and the IRS says proposed rules for LLC members were never finalized. Neither an LLC label nor K-1 box 14 alone settles the issue. Use the K-1 and underlying activity to determine what belongs on Schedule SE (IRS: K-1 instructions).

What is a partner's basis, and why does it matter?

Basis is the partner's running tax investment in the partnership. It helps determine whether a distribution creates gain, how much partnership loss may be deducted, and gain or loss when an interest is sold (IRS: Publication 541; IRS: K-1 instructions).

Start with money and the tax basis of property contributed or the basis of an interest bought. Increase basis for additional contributions, allocated income, and qualifying increases in the partner's share of partnership debt. Reduce it for distributions, allocated losses, nondeductible expenses, and qualifying decreases in that debt share. Basis cannot fall below zero (IRS: Publication 541).

The partner, not the partnership, is responsible for keeping an annual basis record. Start with last year's ending basis and use the IRS partner basis worksheet with this year's K-1 and contribution, distribution, purchase, and debt records. Item L's capital account is not outside basis; item K1 provides liability information. Basis is the first limit on a K-1 loss; Business losses explains the further at-risk, passive activity, and excess business loss limits.

How does an individual report Schedule K-1?

An individual partner uses the K-1 and its attached statements to report each type of income or deduction in the right place on Form 1040. Ordinary trade or business income and guaranteed payments generally go on Schedule E, while interest and capital gains keep their separate character (IRS: K-1 instructions).

These are common destinations, not instructions to copy every box to Schedule E. A partner's loss may be suspended, and rental or portfolio items follow their own rules. The partner includes K-1 items for the partnership tax year that ends within the partner's tax year (IRS: K-1 instructions). If the K-1 appears wrong, request a corrected K-1. A partner reporting an item differently may need Form 8082 under the centralized audit rules; its instructions exclude partnerships that elected out and amounts limited by law.

Do states tax the partnership or its partners?

State treatment depends on where the partnership operates, where income is sourced, and where each partner lives. A state may require its own partnership or LLC return, tax the partners, impose an LLC-level charge, or require withholding for nonresident partners.

If a partner lives outside a state where the partnership earns income, check the partner's return and the partnership's withholding duty there. Some states permit a group return for qualifying nonresident partners; New York requires approval. A state pass-through entity tax election is a separate choice covered in Pass-through entity tax elections.

Who deals with the IRS if the partnership is audited?

Unless a partnership validly elects out of the centralized partnership audit regime, it designates a partnership representative on Form 1065. That representative alone acts for the partnership in the audit; if it is an entity, a designated individual acts for it. Its actions bind the partnership and partners (IRS: representative rules). The IRS generally assesses an audit underpayment at the partnership level. After a final adjustment notice, the representative can sign Form 8988 to pass the adjustments to the reviewed-year partners instead, within 45 days (IRS: audit process).

An eligible partnership may elect out for a tax year on a timely filed Form 1065 with Schedule B-2, signed by a partner or LLC member. Eligibility requires no more than 100 counted partners and only permitted partner types; a partnership or trust partner generally prevents the election (IRS: electing out). The partnership must notify each partner within 30 days after electing out (IRS: Publication 541). If it validly elects out, the IRS can examine partnership items through separate partner-level proceedings (IRS: election explanation). Discuss the election with all partners before filing, especially if ownership has changed.

Example

Illustrative amounts in US dollars. Two individuals own a partnership equally, contribute $10,000 each, and have no partnership debt. The business earns $80,000 of ordinary profit and distributes $20,000 to each partner. Its agreement allocates profit equally and the allocation follows their economic deal.

Each partner's K-1 shows $40,000 of ordinary income, even though each received only $20,000 in cash. Each reports the $40,000, subject to the rules for that income. Each partner's basis starts at $10,000, rises to $50,000 for their income share, and falls to $30,000 after the cash distribution. The $20,000 withdrawal is not taxed again under the general distribution rule. Self-employment tax depends on each partner's status and the nature of the income.

Different for you?

• First Form 1065, a partner joining or leaving, or capital accounts that do not reconcile: gather the agreement, prior K-1s, contribution and distribution records, partner loans, and debt balances; get tax preparation help before allocating income or filing.
• Your spouse or family owns the LLC with you: see Spouse and family LLCs for whether the business files Form 1065.
• A partner lives outside the US: the partnership may have withholding and extra filings; see Foreign partners and withholding.
• A K-1 shows a loss you cannot use in full: see Business losses.
• You are deciding how to take money out: see Paying yourself from an LLC.