How partnership taxation works
A partnership itself doesn't pay income tax. It files an information return (Form 1065) reporting the partnership's income, deductions, and allocations. Each partner receives a Schedule K-1 showing their share of everything, and reports it on their personal return.
Partnership = flow-through. Profits are taxed at the partner level regardless of whether the cash was distributed. You can owe tax on "phantom income" that the partnership retained.
When your LLC becomes a partnership
- Two or more members (owners)
- Exception: spouses in community property states can elect qualified joint venture (disregarded)
- Exception: spouses anywhere can elect to file as two Schedule Cs under the "joint venture" election
Form 1065 basics
Form 1065 is the partnership return. Key parts:
- Page 1: Income and deductions (similar to Schedule C)
- Schedule K: Partners' share of income, deductions, and credits (in aggregate)
- Schedule K-1: Each partner's share, separately. One per partner.
- Schedule L: Balance sheet (if gross receipts ≥ $250k or assets ≥ $1M)
- Schedule M-1/M-2: Reconciliation of book income to tax income and partner capital accounts
The March 15 deadline
Form 1065 is due March 15, a full month before individual returns. This is because partners need their K-1s to file their 1040s.
Late filing penalty: $235 per partner per month (2025). A 2-partner LLC that's 3 months late owes $1,410 in penalties even if there's no tax due.
If you need more time, file Form 7004 by March 15 for a 6-month extension (September 15).
K-1 components
Each partner's K-1 shows:
- Share of ordinary business income (box 1)
- Share of rental income (boxes 2, 3)
- Self-employment earnings (box 14)
- Guaranteed payments (boxes 4a, 4b)
- Capital account beginning/end
- Share of specific deduction items, credits, and other items
Partners plug these into their 1040, Schedule E Part II and related schedules.
Guaranteed payments vs distributions vs allocations
These three concepts confuse new partnerships:
Guaranteed payments
Fixed payments to a partner for services or capital use — essentially a salary equivalent. Deductible by the partnership, ordinary income to the recipient, subject to SE tax. Works like a 1099-NEC but from the partnership.
Distributions
Actual cash or property paid to partners from accumulated profits. Generally not taxable at the time of distribution (partner already taxed on their share of partnership income). Reduces capital account.
Allocations
The partners' shares of income, loss, deductions, and credits — as specified in the partnership agreement. Can differ from ownership percentage if the agreement has "special allocations."
Self-employment tax on partnership income
General partners and LLC members actively working in the business pay SE tax on:
- Their allocable share of ordinary income
- Guaranteed payments received
Limited partners don't pay SE tax on their allocable share, only on guaranteed payments. But the IRS is aggressive about treating "limited partners" who actively work in the business as effectively general partners (the "active vs passive" challenge).
Partnership basis
Every partner has a "basis" in the partnership — starts with capital contribution, goes up with allocated income, down with allocated losses and distributions. You can only deduct losses to the extent of basis. Understanding basis is the biggest conceptual leap for new partnership owners.
Most tax software tracks this automatically once you enter contributions/distributions. But you should understand it.
State complications
- Some states require composite returns for out-of-state partners
- Some states have partnership-level taxes (PTET — Pass-Through Entity Tax — often elective)
- SALT cap workarounds via PTET elections in 30+ states
If partners live in different states, this gets complex fast.
How much does the first year cost?
- Form 1065 preparation by CPA: $900–$2,500
- Form 1065 via TaxAct / TurboTax Business: $200
- Partnership agreement (if not done at formation): $300–$1,500 for a lawyer
- State partnership tax: varies widely
Budget $1,500+ for year-one compliance above what you spent as a solo.
Common mistakes in the first year
- Missing the March 15 deadline (penalties per partner per month)
- Not tracking capital accounts — required on K-1 starting 2020
- Unclear ownership percentages — document at formation
- Mixing guaranteed payments with distributions (different tax treatment)
- Forgetting Form 7004 extension when you can't finish on time
Moving to S-Corp from a partnership
A multi-member LLC can elect S-Corp treatment if all owners are eligible S-Corp shareholders (US persons, not more than 100, etc.). File Form 2553. Same deadlines as for single-member LLCs.
Usually worth it at higher income levels for the same FICA-savings reasons that drive solo S-Corp elections.
We check your K-1 against your 1040.
Missed K-1 entries and mismatched basis calculations are common errors. We flag them.