Business Entities · Partnerships

Partnership income, expenses, distributions, and flow-through (e.g.,self- employment income)

Every difficulty in partnership taxation comes from one design decision: the partnership computes and the partner pays. Two consequences follow and both are tested. The computation happens at the entity, so elections, methods and characterisation are settled there and the partner cannot revisit them. But the tax happens at the partner, so items must arrive in a form the partner’s own return can use — which is why so much has to be stated separately rather than folded into a single number.

The rule

No tax at the entity. a partnership as such is not subject to the income tax — persons carrying on business as partners are liable for income tax only in their separate or individual capacities (IRC § 701)^TY2026

What must be stated separately. each partner takes into account separately their distributive share of the classes IRC § 702(a) lists — short-term and long-term capital gains and losses, § 1231 gains and losses, charitable contributions, dividends, foreign taxes, other separately stated items, and then the residual taxable income or loss (IRC § 702(a))^TY2026

Why it must be. the character of any item included in a partner distributive share is determined as if the item were realised directly from the source from which the partnership realised it, or incurred in the same manner as the partnership incurred it (IRC § 702(b))^TY2026

How the partnership computes. the taxable income of a partnership is computed as for an individual except that the IRC § 702(a) items are separately stated and the partnership is denied the deductions for personal exemptions, foreign taxes, charitable contributions, the net operating loss deduction, the additional itemized deductions for individuals, and depletion for oil and gas wells (IRC § 703(a))^TY2026

Who makes the elections. any election affecting the computation of taxable income derived from a partnership is made by the partnership, except the elections under IRC § 108(b)(5) and (c)(3) on discharge of indebtedness, IRC § 617 on mining exploration expenditures, and IRC § 901 on foreign taxes, which each partner makes separately (IRC § 703(b))^TY2026

How the share is fixed. a partner distributive share is determined by the partnership agreement, except that where the agreement is silent as to an item, or the allocation of an item under the agreement lacks substantial economic effect, the share is determined in accordance with the partner interest in the partnership taking into account all facts and circumstances (IRC § 704(a), (b))^TY2026

The ceiling on losses. a partner distributive share of partnership loss is allowed only to the extent of the adjusted basis of the partner interest at the end of the partnership year in which the loss occurred; any excess is allowed as a deduction at the end of the partnership year in which it is repaid to the partnership (IRC § 704(d)(1), (2))^TY2026

The basis that ceiling runs against. the adjusted basis of a partner interest is the basis determined under IRC § 722 or § 742, increased by the distributive share of partnership taxable income, tax-exempt income and the excess of depletion deductions over the basis of the property, and decreased but not below zero by distributions and by the distributive share of losses and of expenditures neither deductible nor chargeable to capital account (IRC § 705(a))^TY2026

Liabilities as money. an increase in a partner share of partnership liabilities, or in the partner individual liabilities by reason of assuming partnership liabilities, is treated as a contribution of money by that partner to the partnership; a decrease in either is treated as a distribution of money to the partner (IRC § 752(a), (b))^TY2026

Distributions. gain is not recognised to a partner on a distribution except to the extent money distributed exceeds the adjusted basis of the partner interest immediately before it; loss is not recognised except on a liquidating distribution consisting only of money, unrealised receivables and inventory, and then only to the extent the basis of the interest exceeds the money plus the basis of those items. No gain or loss is recognised to the partnership (IRC § 731(a), (b))^TY2026

Self-employment income. in computing net earnings from self-employment there is excluded the distributive share of any item of income or loss of a limited partner, as such, other than IRC § 707(c) guaranteed payments to that partner for services actually rendered to or on behalf of the partnership to the extent established to be in the nature of remuneration for those services (IRC § 1402(a)(13))^TY2026

Current figures

How it works in practice

The list of separately stated items in IRC § 702(a) is not arbitrary, and learning it as a list is the hard way. Each entry is an item whose treatment on the partner’s return depends on something the partnership cannot know: a capital gain has to meet the partner’s own capital losses, a charitable contribution has to meet the partner’s own contribution limits, a foreign tax has to be tested against the partner’s own foreign tax credit position. Anything whose treatment is fixed at the entity goes into the residual figure — ordinary business income (IRC § 702(a)(8)) — and everything else comes out on its own line.

IRC § 703(a)(2) is the mirror of that. The partnership is denied exactly the deductions it cannot properly compute: personal exemptions, foreign taxes, charitable contributions, the net operating loss deduction, the individual itemized deductions in part VII, and oil and gas depletion. It is not that these are disallowed; they are relocated to the partner.

Character is the point of the whole arrangement, and IRC § 702(b) states it in the strongest possible terms. The character of an item is determined as if the partner had realised it directly from the source the partnership realised it from. A partnership dealing in real estate produces ordinary income for its partners even if a particular partner is an investor in every other respect; a partnership that holds an investment produces capital gain for its partners even if one of them is a dealer.

The basis machinery is where computation actually happens, and IRC § 705(a) should be read as a running account rather than a rule. Basis goes up with the distributive share of taxable income and with tax-exempt income — the second is easy to forget and matters, because otherwise the exempt income would be taxed on a later sale. It goes down with distributions and with the share of losses, and also with non-deductible, non-capitalisable expenditures, which is the mirror of the tax-exempt income rule. It never goes below zero.

IRC § 752 is the provision that makes partnership basis behave unlike any other basis. A partner’s share of partnership liabilities is treated as money contributed, so a partner’s basis includes borrowings the partner never made personally. That is why partners can deduct losses funded by partnership debt, and why a reduction in partnership debt is a deemed cash distribution that can produce gain under IRC § 731(a)(1) without a dollar moving.

The loss limitation in IRC § 704(d) is only the first of several. A loss must survive outside basis, then the at-risk rules, then the passive activity rules, then the excess business loss limitation, in that order. A question that says “the partner’s basis is sufficient” has answered only the first gate.

On self-employment income, note what the statute excludes and what it does not. The exclusion is for a limited partner’s distributive share “as such”; guaranteed payments for services actually rendered are carved back in. A general partner’s distributive share from a trade or business is self-employment income in full, which is the single largest practical difference between a partnership and an S corporation for an owner who works in the business.

Scenarios

How this has changed

The architecture of subchapter K has been stable since 1954 and none of the provisions above has been amended recently. What has changed is the stack of limitations that a partnership loss must now pass through after IRC § 704(d). The excess business loss limitation was made permanent by the 2025 Act, so a non-corporate partner whose aggregate business losses exceed the threshold defers the excess indefinitely even where basis, at-risk and passive activity rules are all satisfied. Any material presenting IRC § 704(d) as the last gate is describing a shorter list than the one that now applies.

The self-employment treatment of a limited partner’s distributive share is the live area, and it is live in litigation rather than in legislation. IRC § 1402(a)(13) has not been amended, and the words “limited partner, as such” have carried their weight unchanged since 1977. What has moved is how firmly the Service and the courts read “as such” as a functional test about the capacity in which the income was earned, rather than a formal test about the label in the partnership agreement. Advice that treats a limited partnership interest as automatically outside self-employment income should be given with that uncertainty stated.

Exam focus

The most common shape gives a list of partnership items and asks which are separately stated. Work from the principle rather than the list: an item is separately stated if its treatment depends on facts about the partner. Capital gains, IRC § 1231 items, charitable contributions, qualified dividends, foreign taxes and credits all qualify; wages paid to employees, rent paid, and depreciation on business assets do not.

The second shape gives a partner’s basis, a share of losses, and sometimes a change in liabilities, and asks how much loss is deductible. Order matters: adjust basis for liabilities and distributions first, then apply IRC § 704(d), then note that the excess is suspended rather than lost.

Watch for questions where a partnership distribution exceeds basis. The answer is gain under IRC § 731(a)(1) treated as gain from the sale or exchange of the partnership interest — and remember that a reduction in the partner’s share of liabilities counts as a distribution of money for this purpose.

Check yourself

1. A partnership’s books show ordinary business income of $300,000 after deducting $20,000 of charitable contributions and $15,000 of long-term capital gain included in revenue. What ordinary business income should appear on the Schedules K-1 in aggregate?

Answer: $305,000. The charitable contribution must be added back, because IRC § 703(a)(2)(C) denies the partnership the deduction and IRC § 702(a)(4) requires it to be stated separately. The capital gain must be removed, because IRC § 702(a)(2) requires it to be stated separately. Ordinary business income is $300,000 plus $20,000 less $15,000, and the other two items travel on their own lines.

2. A partner’s outside basis is $40,000 at the end of the partnership year, and their distributive share of the year’s loss is $58,000. How much may they deduct, subject to no other limitation?

Answer: $40,000, with $18,000 suspended. IRC § 704(d)(1) allows the loss only to the extent of the adjusted basis of the interest at the end of the partnership year in which the loss occurred, and IRC § 704(d)(2) allows the excess in a later year. The at-risk, passive activity and excess business loss rules are then applied to the $40,000 in turn.

3. A partnership refinances, reducing a partner’s share of liabilities by $25,000. The partner’s outside basis immediately before the refinancing is $9,000. What is the consequence?

Answer: $16,000 of gain. The decrease in the partner’s share of liabilities is treated as a distribution of money under IRC § 752(b), basis is reduced to zero rather than below it, and the excess of the deemed distribution over basis is gain under IRC § 731(a)(1), treated as gain from the sale or exchange of the partnership interest. No cash was distributed.

4. A partnership receives $8,000 of tax-exempt municipal bond interest and pays a $3,000 fine that is not deductible. How do these affect a 50 percent partner’s outside basis?

Answer: up $4,000 and down $1,500, for a net increase of $2,500. IRC § 705(a)(1)(B) increases basis by the distributive share of income exempt from tax, and IRC § 705(a)(2)(B) decreases it by the share of expenditures that are neither deductible nor properly chargeable to capital account. Both are necessary so that the exempt income is never taxed and the non-deductible expense is never deducted on a later sale.

5. A limited partner receives a $75,000 distributive share and a $30,000 guaranteed payment for services actually rendered to the partnership. What is subject to self-employment tax?

Answer: the $30,000. IRC § 1402(a)(13) excludes a limited partner’s distributive share as such, but expressly does not exclude IRC § 707(c) guaranteed payments for services actually rendered to the extent established to be remuneration for those services. Whether the $75,000 is genuinely excluded also depends on the partner acting as a limited partner in respect of it, which is a question of capacity rather than of the agreement’s wording.