Tax Treatment of Limited Partnerships

As part of AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012, throughout the month of March 2012, we are partnering with our Summit Business Media sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format. In the first article in the series, we looked at the tax treatment of an incentive stock option. In this article, we look at tax treatment of limited partnerships.

How do limited partners report partnership income, gains, losses, deductions, and credits?

The federal income tax laws recognize a partnership as an entity having its own taxable year (within limits) and having its own income and losses. It computes its income much as an individual does. However, once its income for its tax year is determined, the partnership does not, in general, pay taxes. Certain publicly traded partnerships and electing 1987 partnerships are nonetheless subject to tax at the entity level. An electing 1987 partnership is also subject to the “flow through” rules described below. The “flow-through” rules for electing large partnerships are somewhat different than those described here. Also, a partnership may be required to make an accelerated tax payment on behalf of the partners, if the partnership elects not to use a required taxable year.

The partnership reports its income on an information return (Form 1065). It also reports to each individual partner his share of items of partnership income, gains, losses, deductions, and credits (on Schedule K-1, Form 1065). Schedule K-1 identifies separately the partner’s share of combined net short-term capital gains and losses, combined net long-term capital gains and losses, combined net gains and losses from sales or exchanges of “IRC Section 1231 property,” miscellaneous itemized deductions, each class of charitable contributions, taxes subject to the foreign tax credit, and certain other items required by regulation to be stated separately (including: intangible drilling and development costs; any item subject to special allocation that differs from allocation of taxable partnership income or loss generally; and the partner’s share of any partnership items “which if separately taken into account by any partner would result in an income tax liability for that partner different from that which would result if the partner did not take the item into account separately”). Finally, the schedule reports the partner’s share of the partnership taxable income or loss exclusive of separately stated items.

A multi-tiered partnership may not be used to avoid the separately stated requirement. Items that might affect the tax liability of a partner owning his interest indirectly through a multi-tiered partnership arrangement retain their character while flowing through an intermediate partnership. Consequently, such items must be separately stated by each of the different tier partnerships. 

A limited partner then reports on his individual income tax return, subject to any limitations applicable to him, his distributive share of the partnership’s taxable income or loss, and separately stated items of partnership income, gain, loss, deductions, and credits. For example, he includes his share of partnership long-term and short-term capital gains and losses and “IRC Section 1231” gains and losses with his own.  A partner’s share of partnership miscellaneous itemized deductions is combined with his individual miscellaneous deductions for purposes of the 2% floor on such deductions. A partner’s share of the partnership’s investment interest expense is combined with his individual investment interest expense to determine the amount deductible as investment interest. A partner’s distributive shares of income, losses, and credits that are passive to the partner enter into the calculation of the taxpayer’s passive income and losses, and tax attributable to passive activities, to determine whether passive credits may be taken and passive losses deducted.

As a consequence of this “flow through” system of taxability, distributions he may have received during the year are not the measure of a partner’s share of partnership income for a year. A partner may have taxable income without having received a distribution. The existence of conditions upon actual or constructive receipt is irrelevant for this purpose. Similarly, he may have a deductible loss even though he received a distribution.