11.10 How Partners Report Partnership Profit and Loss
A partnership files Form 1065, which informs the IRS of partnership profit or loss and each partner’s share on Schedule K-1. The partnership pays no tax on partnership income; each partner reports his or her share of partnership net profit or loss and special deductions and credits, whether or not distributions are received from the partnership, as shown on Schedule K-1. Income that is not distributed or withdrawn increases the basis of a partner’s partnership interest.
Your share reported to you on Schedule K-1 (Form 1065) is generally based on your proportionate capital interest in the partnership, unless the partnership agreement provides for another allocation.
Filing Instruction
Your partnership must give you a copy of Schedule K-1 (Form 1065), which lists your share of income, loss, deduction, and credit items, and where to report them on your return. For example, your share of income or loss from a business or real estate activity is reported on Schedule E and is subject to passive activity adjustments, if any. Interest and dividends are reported on Schedule B, royalties on Schedule E, and capital gains and losses on Schedule D. Your share of charitable donations is claimed on Schedule A if you itemize deductions. Tax preference items for alternative minimum tax purposes are also listed.
Health insurance premiums.
A partnership that pays premiums for health insurance for partners has a choice. It may treat the premium as a reduction in distributions to the partners. Alternatively, it may deduct the premium as an expense and charge each partner’s share as a guaranteed salary payment taxable to the partner. The partner reports the guaranteed payment shown on Schedule K-1 as nonpassive income on Schedule E and may deduct 100% of the premium on Line 29, Form 1040, as an above-the-line deduction from gross income (12.2).
Guaranteed salary and interest.
A guaranteed salary that is fixed without regard to partnership income is taxable as ordinary wages and not as partnership earnings. If you receive a percentage of the partnership income with a stipulated minimum payment, the guaranteed payment is the amount by which the minimum guarantee exceeds your share of the partnership income before taking into account the minimum guarantee.
Interest on capital is reported as interest income.
Self-employment tax.
As a general partner, you pay self-employment tax on your net partnership income, including guaranteed salary and other guaranteed payments. The self-employment tax is explained in Chapter 45. Limited partners do not pay self-employment tax, unless guaranteed payments are received (45.2).
Special allocations.
Partners may agree to special allocations of gain, income, loss, deductions, or credits disproportionate to their capital contributions. The allocation should have a substantial economic effect to avoid an IRS disallowance. The IRS will not issue an advance ruling on whether an allocation has a substantial economic effect. If the allocation is rejected, a partner’s share is determined by his or her partnership interest.
To have substantial economic effect, a special allocation must be reflected by adjustments to the partners’ capital accounts; liquidation proceeds must be distributed in accordance with the partners’ capital accounts, and following a liquidating distribution, the partners must be liable to the partnership to restore any deficit in their capital.
If there is a change of partnership interests during the year, items are allocated to a partner for that part of the year he or she is a member of the partnership. Thus, a partner who acquires an interest late in the year is barred from deducting partnership expenses incurred prior to his entry into the partnership. If the partners agree to give an incoming partner a disproportionate share of partnership losses for the period after he or she becomes a member, the allocation must meet the substantial economic effect test to avoid IRS disallowance.
See IRS regulations to Code Section 704 and Form 1065 instructions for further details.
Reporting transfers of interest to IRS.
If you transfer a partnership interest that includes an interest in partnership receivables and appreciated inventory, you must report the disposition to the partnership within 30 days, or, if earlier, by January 15 of the calendar year after the year of the transfer. The partnership in turn files a report with the IRS on Form 8308. You must also attach a statement to your income tax return describing the transaction and allocating basis to the receivables and inventory items. The IRS wants to keep track of such dispositions because partners have to pay ordinary income tax on the portion of profit attributable to the receivables and inventory.
Within 30 days of your transfer, provide the partnership with a statement that includes the date of the exchange and identifies the transferee (include Social Security number if known). You can be penalized for failure to notify the partnership. You and your transferee should receive a copy of the Form 8308 that the partnership will send to the IRS along with its Form 1065.