Partnership and LLC Taxes: How Pass-Through Entities Are Taxed
Business Taxes · BUSINESS TAXES
Partnerships and multi-member LLCs don't pay income tax themselves — profits pass through to the partners. Learn how partnership taxation works, K-1s, basis, guaranteed payments, and self-employment tax.
When two or more people go into business together without forming a corporation, the IRS treats them as a partnership by default — and a multi-member LLC is taxed the same way unless it elects otherwise. Partnership taxation is flexible and avoids the double taxation of C corporations, but it has its own rules around profit allocation, basis, and self-employment tax that surprise many new business owners.
How Partnership Taxation Works
A partnership is a pass-through entity. It files an informational return (Form 1065) but pays no federal income tax itself. Instead, each partner receives a Schedule K-1 reporting their share of income, deductions, and credits, and they report those amounts on their personal returns — whether or not the cash was actually distributed. This 'phantom income' surprise is one of the most important things to understand: you can owe tax on profits the partnership reinvested rather than paid out to you.
Profit and Loss Allocations
Partnerships have flexibility that corporations don't: profits and losses can be allocated among partners in ways that differ from their ownership percentages, as long as the allocations have 'substantial economic effect' under the tax rules. This is spelled out in the partnership agreement. Special allocations are powerful but technical — getting them wrong can cause the IRS to reallocate income based on ownership interests.
Partnership Basis — Why It Matters
Each partner has a 'basis' in the partnership that goes up with contributions and allocated income, and down with distributions and allocated losses. Basis matters because:
• You can only deduct losses up to your basis
• Distributions above your basis are taxed as capital gain
• Basis determines gain or loss when you sell your interest
Unlike an S corp, a partner's basis includes their share of the partnership's debt, which can allow larger loss deductions.
Guaranteed Payments and Self-Employment Tax
Partners aren't employees — they don't get a W-2. Instead, fixed compensation for services is paid as a 'guaranteed payment,' which is deductible by the partnership and taxable to the partner. General partners generally owe self-employment tax on their share of business income plus guaranteed payments. Limited partners' treatment can differ. This is a key contrast with S corps, where distributions escape self-employment tax.
LLCs: Choosing How to Be Taxed
An LLC is a legal entity, not a tax category. By default, a single-member LLC is taxed as a sole proprietorship and a multi-member LLC as a partnership. But an LLC can elect to be taxed as an S corporation or C corporation instead. This flexibility is a major reason the LLC is the most popular small-business structure — you get liability protection and can pick the tax treatment that fits.
Frequently Asked Questions
Does a partnership pay income tax?
No. A partnership files Form 1065 for information only and passes income through to the partners via K-1s. The partners pay the tax on their personal returns.
Do I owe tax on partnership profits I didn't receive?
Often yes. Partners are taxed on their allocated share of income whether or not it was distributed. This 'phantom income' is why partnership agreements frequently require tax distributions.
How is a multi-member LLC taxed?
By default, like a partnership — pass-through with K-1s. It can elect to be taxed as an S corp or C corp instead by filing the appropriate IRS form.
Do partners pay self-employment tax?
General partners generally pay self-employment tax on their share of business income and guaranteed payments. Limited partners' treatment can differ depending on their involvement.
What is partnership basis and why does it matter?
Basis is your investment in the partnership for tax purposes. It limits the losses you can deduct and determines how distributions and a sale of your interest are taxed.