814 / How is the income from a partnership taxed?

With the exception of certain publicly traded partnerships, a partnership, as such, is not taxed.¹ However, the partnership must file an information return on Form 1065, showing taxable ordinary income or loss and capital gain or loss. The partnership is regarded as an entity for the purpose of computing taxable income, and business expenses of the partnership may be deducted. In general, prior to the 2017 Tax Act, taxable income was computed in the same manner as for individuals; but the standard deduction, personal exemptions, and expenses of a purely personal nature are not allowed.² The deduction for production activities may also have been allowed prior to its repeal for tax years beginning in 2018 and beyond (see Q 798).

Each partner must report his share of partnership profits, whether distributed or not, on his individual return. A partner’s distributive share is determined either on the basis of the partner’s interest or by allocation under the partnership agreement. Allocation by agreement must have a “substantial economic effect.” Special allocation rules apply where the partner’s interest changes during the year.³

A person is a partner if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether he acquired his interest by purchase or gift. Generally, such a person will be taxable on his share of partnership profits. If capital is not an income-producing factor, the transfer of a partnership interest to a family member may be disregarded as an ineffective assignment of income, rather than an assignment of property from which income is derived. Where an interest is acquired by gift (an interest purchased by one family member from another is considered to have been acquired by gift), allocation of income among the partners according to the partnership agreement will not control to the extent that: (1) it does not allow a reasonable salary for the donor of the interest; or (2) the income attributable to the capital share of the donee is proportionately greater than the income attributable to the donor’s capital share.⁴ The transfer must be complete and the family member donee must have control over the partnership interest consistent with the status of partner. If he is not old enough to serve in the capacity of partner, his interest must be controlled by a fiduciary for his benefit.