Your business partnership is off to a strong start, but tax season brings a stack of forms that don’t exactly speak plain English. Instead of the simple W-2 world you may be used to, you’re now seeing references to Form 1065, Schedule K-1, and “pass-through taxation.”

What’s happening is that partnerships are taxed under a different framework than corporations or employees. The IRS generally treats them as pass-through entities, meaning the partnership itself doesn’t pay federal income tax. Instead, profits, losses, deductions, and credits flow through to the partners, who report them on their own returns.

That might feel like a lot to navigate, but it also comes with benefits. Unlike corporations, partnerships avoid the double layer of taxation on profits. And with recent changes under the One Big Beautiful Bill Act of 2025 (OBBBA), partnerships can now take advantage of permanent 100% bonus depreciation, higher Section 179 expensing limits, and clarified rules on payments made from partnerships to partners.

As Jess Holt, one of Town’s senior tax managers, explains: “Partnerships have more moving parts than S corps or sole proprietorships, but that complexity can work to your advantage once you know the rules.”

This guide walks through the essentials — from Form 1065 and Schedule K-1 to self-employment tax, state PTET elections, and the filing rules every business owner should know.

What Makes Partnership Taxation Different

Partnerships don’t pay federal income tax at the business level. Instead, profits, losses, deductions, and credits “pass through” to the partners, who report them on their own returns. Think of your partnership like a pipeline: income flows through the entity to the owners, and the tax is paid only once — at the individual level.

This is fundamentally different from corporations, which face double taxation. A C corporation pays corporate income tax on its profits (21% rate), and then shareholders pay tax again when profits are distributed as dividends.

Example: A three-partner consulting business earns $200,000 in profit. As a corporation, it would first pay about $42,000 in corporate tax, leaving $158,000. That $158,000 would be taxed again when distributed to the owners. As a partnership, the full $200,000 flows through to the partners’ returns — no corporate-level tax.

Forming a Partnership: What Can Be Contributed

Partnerships usually start with partners contributing something of value — but not all contributions are treated the same way for tax purposes.

• Cash: The simplest option. Your basis equals the amount you put in.

• Property: When you contribute property, your basis in the partnership is generally the property’s adjusted tax basis. If the property has a mortgage, your share of that liability may also increase your basis.

• Services: Contributing services in exchange for a partnership interest usually creates taxable income equal to the fair market value of the interest received. Sweat equity isn’t tax-free.

• Promissory notes: A promise to contribute doesn’t usually increase your basis until the money or property is actually delivered, though personally liable notes may affect your share of debt basis.

Example: You contribute equipment worth $100,000 that carries a $40,000 loan. The partnership assumes the loan. Your initial basis is $60,000, plus your share of the partnership’s debt.

Check with your accountant before finalizing contributions. Basis starts here, and mistakes at formation — especially with property that has debt or when services are involved — can create tax problems down the road.

Multi-Member LLCs and Partnership Taxation

If your business is an LLC with more than one member, the IRS defaults to treating you as a partnership for tax purposes. That means you follow the same rules: file Form 1065, issue Schedule K-1s, and pass income through to members’ personal returns.

The terminology may differ — “members” instead of “partners” — but the tax treatment is the same. Unless you elect to be taxed as a corporation (C or S corp), your multi-member LLC is a partnership by default.

Jess Holt often reminds business owners: “Many LLCs don’t realize they’re partnerships for tax purposes until their first K-1 shows up. Understanding this early can save a lot of surprises at filing time.”

Form 1065: The Partnership’s Tax Return

Every partnership must file Form 1065, U.S. Return of Partnership Income. This is an information return — it reports the partnership’s income, deductions, and other financial details, but the partnership itself usually doesn’t pay tax.

Key deadlines for calendar-year partnerships:

• Form 1065: due March 15 (or the next business day if March 15 falls on a weekend or holiday).

• Individual partner returns: due April 15 (or the next business day).

• Automatic extension: File Form 7004 to extend the partnership return to September 15 (or the next business day).

Missing the March deadline is costly. The IRS assesses penalties of $245 per partner, per month, up to 12 months. For a three-partner business, that’s $735 per month until the return is filed.

Jess Holt notes: “The March 15 deadline is the one that sneaks up on people. Unlike personal returns, partnerships file a month earlier. A smooth February makes for a painless March.”

Understanding Schedule K-1: Your Individual Tax Roadmap

Along with Form 1065, every partner receives a Schedule K-1. This form shows your share of the partnership’s income, deductions, credits, and other tax items. It’s your personal roadmap for reporting partnership activity on your own return.

What you’ll see on a K-1:

• Ordinary business income or loss

• Capital gains and losses

• Deductions and credits that flow through to you

• Self-employment income (if active partner)

Important: You don’t file the K-1 with your return. Instead, you use the numbers from it to complete schedules like Schedule E.

The partnership must provide K-1s to partners by the Form 1065 due date (March 15, or the next business day with extensions). If you file your personal return early and don’t have your K-1 yet, you’ll need to wait or file an extension.

How Partners Are Taxed on Their Share

Partnership taxation isn’t just about splitting profits. How those profits are treated depends on the partner’s role, the type of payment, and recent IRS and court rulings.

Self-Employment Tax

If you’re a general partner (or an LLC member actively involved in the business), your share of partnership income is generally subject to self-employment (SE) tax.

• The SE tax rate for 2025 is 15.3%, which includes:

  • 12.4% Social Security tax on earnings up to $176,100, and

  • 2.9% Medicare tax on all earnings.

• High earners may also owe an additional 0.9% Medicare surtax on income above certain thresholds ($200,000 for single filers, $250,000 for joint filers).

This means that even if you don’t take cash distributions, you may still owe SE tax on your allocated income.

The Limited Partner Exception — Narrower Than It Looks

Historically, limited partners avoided SE tax on their distributive share of partnership income (paying it only on guaranteed payments). But recent Tax Court cases, including Soroban Capital Partners, have tightened this exception. Courts now apply a functional analysis test:

• Are you truly a passive investor? Or

• Do you work in the business, make decisions, or get paid primarily for services?

If you’re actively running the business, expect SE tax to apply regardless of whether your title says “limited partner.”

Guaranteed Payments

Partnerships can make guaranteed payments to partners for services or for the use of capital, even when the business isn’t profitable. These function much like a salary substitute:

• They are deductible by the partnership.

• They are always subject to SE tax.

• They are reported on the partner’s Schedule K-1 (Box 4).

Note: Partnerships do not issue Form 1099-NEC to partners for guaranteed payments. They appear only on the K-1.

No Salaries for Partners or LLC Members

Partners and LLC members taxed as partnerships cannot pay themselves a W-2 salary. Instead, compensation comes in two forms:

• Guaranteed payments for services, which are deductible by the partnership and subject to SE tax.

• Distributions of profits, which reduce basis and are generally not deductible by the partnership.

If you want to pay yourself a traditional salary, the business must elect to be taxed as an S corporation.

Jess Holt puts it this way: “Guaranteed payments are how partnerships make sure working partners get paid, even in a slow year. Just don’t confuse them with W-2 wages or 1099 income — the tax treatment is its own animal.”

Partnership Distributions: Cash/Property vs. Taxable Income

One of the most common surprises for new partners is that taxable income and cash distributions don’t always line up.

• Taxable income flows regardless of distributions. If your K-1 shows $50,000 of income, you’ll report it on your return whether or not the partnership actually gave you cash.

• Distributions are not automatically taxable. Generally, cash distributions reduce your basis but aren’t taxable until they exceed it. Once distributions push your basis below zero, the excess is taxed as a capital gain.

• Proportionate vs. special allocations. Distributions don’t have to be in exact proportion to ownership percentages — the partnership agreement controls. But the IRS requires that allocations have “substantial economic effect.” In practice, this means the allocations must be tied to how the partners share real economic benefits and burdens.

• Timing. Distributions can be made during the year or after year-end. Many partnerships make “tax distributions” — cash payments to help partners cover their tax liabilities from pass-through income.

Example: Your partnership earns $120,000. Your K-1 shows $40,000 of income, but the partnership only distributes $20,000 in cash. You’ll still pay tax on the full $40,000, and the $20,000 cash just reduces your basis.

Property Distributions: Partnerships can also distribute property, not just cash. In most cases, the partner takes the partnership’s basis in the property, limited by their outside basis in the partnership.

If the distribution reduces your basis below zero, the excess is taxed as a gain. And certain assets, like inventory or receivables (“hot assets”), may trigger special rules that convert part of the distribution into ordinary income.

Because property distributions can have unexpected effects — especially if debt is involved — it’s best to run the numbers with an accountant before transferring assets out of the partnership.

Check your basis before taking distributions: You can only take tax-free distributions up to your basis in the partnership. If you withdraw more than your basis, the excess is taxable as a capital gain. Basis changes every year with income, losses, contributions, and prior distributions, so it’s best to confirm with your accountant before pulling out cash.

Remember: Distributions are not a substitute for salary. Partners and LLC members taxed as partnerships cannot be W-2 employees — compensation comes only through guaranteed payments and profit distributions.

Jess Holt often reminds partners: “Don’t assume the cash you receive equals the income you’ll be taxed on. Planning for tax distributions is one of the smartest moves a partnership can make.”

State Tax Complications

Partnership taxation gets more complex when multiple states are involved. Unlike federal tax, each state sets its own rules, which can create layers of compliance.

Key issues to watch:

Multi-state nexus: If your partnership does business in more than one state, it may need to file returns in each state and allocate income accordingly.

Partner state residency: Partners usually owe tax to their home state on their entire share of partnership income, but they may also owe tax to states where the partnership operates. Credits for taxes paid to other states often apply, but the math isn’t always straightforward.

Pass-Through Entity Taxes (PTETs): Many states now allow partnerships to elect a PTET as a workaround to the federal $10,000 cap on deducting state and local taxes (SALT). With a PTET election, the partnership pays state tax at the entity level. This payment becomes a federal deduction for the partnership, while partners claim a credit on their personal state return for tax paid on their behalf.

Jess Holt explains: “PTET elections can be a real tax saver, but the rules vary state by state. Some require annual elections, some lock you in for multiple years, and others have different credit mechanics. A wrong move here can mean partners don’t get the benefit you intended.”

Planning Opportunities and Pitfalls

Partnership taxation offers flexibility, but that flexibility comes with traps if you don’t plan ahead.

Take Advantage of Losses

Partnership losses can offset other income on a partner’s return — but only if you have enough basis (your tax investment in the partnership), are at risk for the loss, and meet passive activity rules.

Example: You invest $20,000 in your partnership, and your share of partnership income adds another $10,000. Your basis is now $30,000. If the partnership generates a $40,000 loss, you can only deduct $30,000 this year. The extra $10,000 carries forward until you increase your basis.

Active vs. Passive Participation: Whether you’re considered active or passive matters for how you use partnership income and losses:

• Active partners (general partners or LLC members materially involved in the business) report income as non-passive. Their share may be subject to self-employment tax, but they can usually use losses to offset other active income.

• Passive partners (limited partners or investors not involved in operations) report income as passive. Passive income can only be offset by passive losses. Losses generally can’t reduce wages or other active income.

If you’re passive, a loss on your K-1 may not provide an immediate benefit — instead, it carries forward until you generate passive income or dispose of your interest.

Jess Holt points out: “The active vs. passive test trips up a lot of people. You can’t just ‘elect’ to make a loss active — the IRS looks at your level of involvement. Document your hours and role if you want active treatment.”

Watch Your Basis Year-Round

Basis goes up with contributions and your share of income, and down with losses and distributions. Many partners don’t track basis until tax time — but you need it to know whether losses are deductible and to avoid surprises when taking distributions.

Time Your Income and Payments

Partners may have some flexibility in timing guaranteed payments or distributions. Coordinating year-end activity can shift income between tax years, which matters for estimated tax payments.

Estimated Tax Payments

Since partnerships don’t withhold tax, partners must generally make quarterly estimated payments to the IRS. Skipping them often triggers underpayment penalties.

Don’t forget about states. Many states require partners to make separate estimated tax payments, while others mandate partnership-level withholding on behalf of nonresident partners. The rules vary widely, so check each state where the partnership has filing obligations.

OBBBA Planning Updates

Recent changes under the OBBBA expand opportunities for partnerships:

• Bonus depreciation: Now permanently set at 100% for qualified property.

• Section 179 expensing: Increased to $2.5 million, with a new $4 million phase-out threshold, both indexed for inflation starting in 2026.

• Research & experimental (R&E) costs: Domestic R&E is once again immediately deductible after 2024; foreign R&E still requires 15-year amortization.

Filing Requirements: Beyond Form 1065

Form 1065 and the partner K-1s are just the start. Depending on your partnership’s size and activities, additional requirements may apply.

Electronic Filing Mandate

The IRS has expanded e-filing rules. If a partnership files 10 or more returns of any type in a calendar year (including W-2s, 1099s, and state forms), it must e-file all of them — including Form 1065. Paper filing is no longer an option once you cross the 10-return threshold.

International Reporting (Schedules K-2 and K-3)

If your partnership has foreign partners or activities, you may need to file Schedules K-2 and K-3 to report international tax items. However, the IRS allows an exception if:

• All partners are U.S. citizens or resident aliens,

• The partnership has only limited foreign activity, and

• The partnership notifies its partners that no K-3 information will be provided.

This exception can save a lot of paperwork, but eligibility depends on meeting all the conditions.

Schedule M-3

Large partnerships face an extra layer of reporting. Partnerships with total assets of $10 million or more or total receipts of $35 million or more must file Schedule M-3 to reconcile book and tax income. Smaller partnerships can stick with the simpler Schedule M-1.

When to Get Professional Help

Partnership taxation is full of details that can trip up even experienced business owners. Professional guidance is worth considering if:

• Your partnership operates in multiple states.

• You have foreign partners or international activities.

• The partnership agreement includes complex profit- or loss-sharing provisions.

• Self-employment tax planning becomes a major factor.

• You’re restructuring the partnership or bringing in new investors.

Jess Holt adds: “The most common mistake I see is partners not tracking their basis year after year. That one detail determines whether you can deduct losses or whether a distribution is taxable — but it’s often overlooked until the IRS comes calling.”

Professional support isn’t just about compliance — it’s about planning. The right advisor can help structure agreements, manage state elections like PTETs, and maximize new deductions under the OBBBA.

Your Next Steps

Partnership taxation follows logical rules once you see how the pieces fit, but the details can make or break your filing season. Here’s how to stay ahead:

• File or extend on time: Use Form 7004 if you need the automatic six-month extension to September 15. Remember — March 15 comes fast, and weekends push due dates to the next business day.

• Review your partnership agreement: Make sure income and loss allocations in the agreement match how you actually intend to split profits. A mismatch here is one of the most common audit triggers.

• Stay on top of state obligations: Identify which states your partnership has nexus in, and confirm whether PTET elections make sense for your group of partners.

• Revisit your tax planning with OBBBA in mind: Take advantage of the permanent 100% bonus depreciation, higher Section 179 expensing limits, and new R&E expensing rules for domestic research. Even small partnerships can benefit.

Jess Holt sums it up well: “The difference between reactive compliance and proactive planning isn’t a few forms — it’s thousands of dollars in tax savings.”

Ready to simplify your partnership tax obligations? Town's tax advisors can help you keep filings on track and make the most of the current compliance and future planning strategies.

This content is for educational purposes only and does not constitute personalized tax advice. Tax laws are complex and subject to change. Individual circumstances can vary significantly, and strategies that work for one taxpayer may not be suitable for another.