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Why a partner reports more income than he receives in cash (MS Word)
Why a partner reports more income than he receives in cash (.pdf)
Why a partner reports more income than he receives in cash
Dear Reader:
You recently asked why, in a given year, you may be taxed on more
partnership income than was distributed to you from the partnership
in which you are a partner.
The answers lies in the way partnerships and partners are taxed.
Unlike a regular corporation, a partnership isn't subject to income
tax. Rather, each partner is taxed on the partnership's earnings,
whether or not they are distributed. Similarly, if a partnership has
a loss, the loss is passed through to the partners. (Various rules,
however, may prevent a partner from currently using his share of a
partnership's loss to offset other income.)
While a partnership isn't subject to income tax, it's treated as a
separate entity for purposes of determining its income, gains,
losses, deductions and credits. This makes it possible to pass
through to partners their share of these items.
A partnership must file an information return (Form 1065). On
Schedule K of this form, the partnership separately identifies many
items of income, deduction, credits, etc. This is so that each
partner can properly treat items that are subject to limits or other
rules that could affect their correct treatment at the partner's
level. Examples of such items include capital gains and losses,
charitable contributions, and interest expense on investment debts.
Each partner gets a Schedule K-1 showing his share of partnership
items.
Basis and distribution rules ensure that partners aren't taxed
twice. A partner's initial basis in his partnership interest (the
determination of which varies depending on how the interest was
acquired) is increased by his share of partnership taxable income.
When that income is paid out to partners in cash, they aren't taxed
on the cash if they have sufficient basis. Rather, partners merely
reduce their basis by the amount of the distribution. If a cash
distribution exceeds a partner's basis, then the excess is taxed to
the partner as a gain, which often is a capital gain.
Example:
Smith and Jones each contributes $10,000 to form a partnership. The
partnership has $80,000 of taxable income in Year 1, during which it
makes no cash distributions to Smith or Jones. Smith and Jones each
picks up $40,000 of taxable income from the partnership as shown on
their K-1s. Each has a starting basis of $10,000, which is increased
by $40,000 to $50,000. In Year 2, the partnership breaks even (has
zero taxable income) and distributes $40,000 to Smith and a like
amount to Jones. The cash distributed to them is received tax-free.
Each of them, however, must reduce the basis in his partnership
interest from $50,000 to $10,000.
The discussion above is an overview and, therefore, does not touch
on all the rules. For example, many other events require basis
adjustments and there are a host of special rules covering noncash
distributions, distributions of securities, liquidating
distributions, and other matters.
Please call if you wish to further discuss any aspect of how you are
taxed as a partner.