Partnership

A partnership is a business arrangement in which two or more persons carry on a trade or business together and share in its results. For federal tax purposes it is a defined term with an unusually wide reach: Internal Revenue Code section 7701(a)(2) provides that "the term 'partnership' includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation." Section 761(a) repeats that definition for Subchapter K, the part of the Code that governs how partnerships are taxed.

Its defining tax feature is that it is a conduit. The partnership itself owes no federal income tax. It files an information return, Form 1065, "U.S. Return of Partnership Income," and reports each partner's share of income, deductions, credits and other items on a Schedule K-1. Each partner then reports that share on their own return.

This page is filed under the slug business-partnership to keep its URL clear of the unrelated family-law sense of the word. The display name is the Code's own term, which is simply "partnership."

One federal term, several state-law forms. The distinctions people draw between kinds of partnership are creatures of state law, and they govern liability rather than tax:

• A general partnership is the default. Every partner participates in management and every partner is personally liable for the partnership's obligations. It can come into existence without anyone filing anything, which is why two people who start a business together and never paper it are often surprised to learn they have one.
• A limited partnership has at least one general partner with management authority and unlimited liability, and limited partners whose exposure is capped at their investment and whose participation in management is restricted.
• A limited liability partnership is a form available in most states, typically to professional firms, in which partners are shielded from liability arising from other partners' conduct.

Section 7701(a)(2) reaches all of them, and reaches a multi-member limited liability company that has not elected corporate treatment as well. So the federal tax analysis on this page applies to each, while the liability analysis does not transfer between them at all.

Taxed on the share, not on the cash. The single fact that surprises new partners most is that a partner's tax liability follows the allocation, not the distribution. A partnership that earns $200,000 and reinvests all of it still issues Schedules K-1 allocating $200,000, and the partners owe tax on it. Partnership agreements commonly address this with a mandatory tax distribution, precisely because the Code does not.

Self-employment tax reaches a general partner's share. A general partner's distributive share of the partnership's trade or business income is generally net earnings from self-employment, so it bears self-employment tax on top of income tax. That is a meaningful difference from an S corporation, where only the owner-employee's wages bear employment tax, and it is one of the main reasons a profitable service partnership eventually looks at converting. Payments to a partner for services or for the use of capital, determined without regard to partnership income, are treated differently again; the Code calls them guaranteed payments.

The partnership agreement is doing more work than most people realize. Absent an agreement, state default rules divide profits, losses and management rights, and those defaults are frequently not what the partners intended. The agreement is also where the allocation of specific items, the treatment of contributed property, buyout terms on a partner's death or exit, and the tax distribution obligation live. In a partnership, the document is not boilerplate; it is the operating system.

An election out exists, and it is narrow. Section 761(a) lets the members of an unincorporated organization elect to exclude it from all or part of Subchapter K, but only in three situations: where it is availed of "for investment purposes only and not for the active conduct of a business," "for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted," or by securities dealers for a short underwriting period. An ordinary operating business does not qualify.

Related structures that are partnerships under a different name. A master limited partnership is a publicly traded partnership; a family limited partnership is a limited partnership used to hold and transfer family assets. Both are governed by Subchapter K plus their own additional rules.

The annual cycle has four steps.

1. The partnership computes its results for the year, at the entity level, applying most of the ordinary income and deduction rules a business faces.
2. It files Form 1065, which reports those results and pays no tax.
3. It issues a Schedule K-1 to each partner, allocating that partner's distributive share of each item according to the partnership agreement.
4. Each partner reports the K-1 items on their own return, and pays income tax, and for a general partner self-employment tax, on their share.

A hypothetical makes the cash-versus-tax gap concrete. Ana and Ben own a design partnership equally. In one year it earns $180,000 of net profit, and they agree to distribute only $60,000 total, keeping the rest to fund a studio build-out.

• Each receives a Schedule K-1 allocating $90,000 (half of $180,000).
• Each actually receives $30,000 in cash.
• Each reports $90,000 of partnership income on their own return, not $30,000.
• If Ana's combined federal marginal rate on that income were 24 percent, her income tax on it would be $90,000 × 24% = $21,600, and self-employment tax would be charged on top of that. Her $30,000 distribution does not cover both.

The gap is the reason partnership agreements commonly require a distribution at least large enough to cover the tax on the allocated income. These are hypothetical figures illustrating the mechanism, not tax advice about any particular arrangement.

Pros

• No entity-level income tax, so profit is taxed once rather than twice.
• Losses generally flow through to the partners, subject to basis, at-risk and passive activity limits, which a C corporation's losses do not.
• Allocations can be flexible: partners are not confined to a single class of interest the way S corporation shareholders are confined to one class of stock.
• A general partnership requires no state filing to exist, so the structure is cheap to start.
• Owners of a partnership may be eligible for the qualified business income deduction on their share.

Cons

• A partner is taxed on their allocated share whether or not any cash is distributed, which can produce a tax bill with nothing behind it.
• A general partner has unlimited personal liability for partnership obligations, including those created by another partner.
• A general partner's share generally bears self-employment tax, which an S corporation shareholder's distributions do not.
• Subchapter K is among the most complex parts of the Code, and the compliance cost of a partnership return exceeds that of a sole proprietorship by a wide margin.
• Without a written agreement, state default rules govern profit splits, management and exit, and the defaults are frequently not what the partners would have chosen.