Partnership Tax Basics

You started a business with a partner, the money runs through a shared account, and now someone has mentioned Form 1065, "K-1s," and a March deadline you've never heard of. Partnership taxation is genuinely different from anything a sole proprietor or W-2 employee has dealt with — and the penalties for learning it late are charged per partner, per month. Here's how it actually works, with the 2026 deadlines and dollar figures that matter.

How is a partnership actually taxed?

A partnership generally pays no federal income tax itself. Instead, it files Form 1065 — an informational return — and "passes through" its income, deductions, and credits to the partners, who report their shares on their personal returns. This applies to general partnerships, limited partnerships, and, importantly, multi-member LLCs, which are taxed as partnerships by default unless they elect corporate treatment.

Two consequences surprise almost every new partner:

• You're taxed on your share of profit whether or not you took the cash. If the partnership earned $120,000 in 2025 and left it all in the business bank account, the partners still pay tax on $120,000. Accountants call this phantom income, and it's the number-one source of April surprises.
• The character of income passes through too. Ordinary business income, rental income, interest, capital gains, and Section 179 deductions each keep their identity on the way to your return.

There's an upside to pass-through status: qualifying partners may claim the Section 199A qualified business income (QBI) deduction — generally up to 20% of qualified business income — which the 2025 tax law made permanent. For 2026, income-based limits begin phasing in above $201,750 of taxable income for single filers and $403,500 for joint filers. Our 2026 tax changes hub covers the full details.

What is a Schedule K-1, and what do you do with it?

Each partner receives a Schedule K-1 (Form 1065) showing their share of every item — ordinary income, guaranteed payments, distributions, capital account changes, and more. You (or your preparer) carry those figures onto your Form 1040, mostly via Schedule E.

Practical points worth knowing:

• You can't file your personal return properly until the K-1 arrives. If your partnership extends to September, your 1040 usually needs an extension too.
• The K-1 is not a bill or a payment. It reports your taxable share, which often differs from the cash you received.
• K-1s now report tax-basis capital accounts, which the IRS uses to check whether losses and distributions were handled correctly. Sloppy capital accounts are a common audit trigger for small partnerships.

When is Form 1065 due — and what does filing late cost?

Form 1065 is due the 15th day of the third month after year-end — a full month before personal returns. For a calendar-year partnership, the 2025 return was due March 16, 2026 (March 15 fell on a Sunday). A six-month extension on Form 7004 moves the paperwork to September 15, 2026 — but it extends the return, not any partner-level tax payments.

That penalty deserves emphasis: a three-partner LLC that files four months late owes roughly $3,060 ($255 × 3 partners × 4 months) — for a return that itself owed no tax. First-time penalty abatement or reasonable-cause relief is sometimes available, but prevention is far cheaper than the cure.

Do partners pay self-employment tax?

Generally, yes — and this is where partnership taxation gets expensive if nobody plans for it.

• General partners and active LLC members typically owe self-employment tax on their distributive share of trade or business income plus any guaranteed payments. For 2026 that means 12.4% Social Security tax on the first $184,500 of combined self-employment earnings and wages, plus 2.9% Medicare tax on everything (and an extra 0.9% at higher incomes).
• Limited partners are generally exempt on their distributive share (though not on guaranteed payments) — but be careful: courts and the IRS have made clear that a state-law "limited partner" label alone doesn't settle the question. What matters is whether you're functionally active in the business.

One rule catches nearly everyone: partners are not employees of their own partnership. No W-2, no withholding. That means partners generally must make quarterly estimated tax payments on their share of income — miss those and underpayment penalties accrue at the IRS interest rate, which has run 6–7% during 2026.

Why do basis and distributions matter so much?

Your outside basis — roughly, what you put in, plus income allocated to you and your share of certain partnership debt, minus losses and distributions — is the meter that controls two things:

1. Distributions are generally tax-free up to your basis. Take out more than your basis and the excess is usually taxed as capital gain.
2. Losses are deductible only up to your basis (and then must also clear at-risk and passive-activity hurdles). Excess losses aren't lost; they're suspended until basis is restored.

A quick hedged example: suppose in tax year 2025 you contributed $20,000 to a two-person LLC, were allocated $60,000 of income, and took $50,000 in distributions. You'd pay tax on the $60,000 allocation; the $50,000 distribution would generally be tax-free because your basis (roughly $80,000 before the draw) covered it. Reverse the numbers — small basis, big distribution — and part of that draw becomes taxable gain. Exact results depend on debt allocations and your partnership agreement, which is why basis schedules should be updated every year, not reconstructed in a panic later.

Guaranteed payments — fixed compensation to a partner for services, paid regardless of profits — are their own category: ordinary income and self-employment income to the recipient, and a deduction for the partnership. They're the partnership world's substitute for salary.

What trips up new partnerships most often?

After the phantom-income surprise, these are the classics:

• Putting a partner on payroll. Partners generally can't receive W-2 wages from their own partnership; doing it anyway creates payroll-tax and benefits messes that take real work to unwind.
• Assuming the deadline is April 15. It's mid-March. See the penalty math above.
• Special allocations without substance. Partnerships can allocate items disproportionately (say, 70/30 profits on a 50/50 ownership split), but only if the allocation has substantial economic effect under Section 704(b) and is documented in the agreement. Handshake allocations invite reallocation by the IRS.
• Ignoring state-level opportunities. With the SALT deduction cap at $40,400 for 2026, many states' pass-through entity tax (PTET) elections let the partnership pay state tax at the entity level and deduct it federally — often real money for profitable partnerships in high-tax states.
• Not naming a partnership representative. Under the centralized audit rules, this person has sweeping authority in an IRS exam. Choose deliberately, in writing.

If several of these hit close to home, don't wait for the notice to arrive. Problems come here to get solved. And if you're still deciding whether a partnership is even the right wrapper versus an S corporation, our LLC vs. S-corp comparison tool is a fast place to start.

FAQ

Does a multi-member LLC really have to file a partnership return?

Generally yes. An LLC with two or more members is taxed as a partnership by default and files Form 1065, unless it elects to be taxed as a corporation. (A narrow exception: married couples in community-property states can sometimes treat a jointly owned LLC as a disregarded entity.)

Are partnership distributions taxable?

Usually not by themselves — you've already been taxed on your share of income via the K-1. Distributions generally become taxable only when they exceed your outside basis, or in certain cases involving hot assets or property distributions.

Can the partnership pay for a partner's health insurance?

Yes. Premiums paid on a partner's behalf are typically treated as guaranteed payments — income to the partner — and the partner may then generally claim the self-employed health insurance deduction on their 1040. The net result is usually favorable, but the bookkeeping has to be right.

What if the partnership had little or no activity this year?

Once a partnership exists and has income or deductible expenses, a Form 1065 is generally required — and the $255-per-partner-per-month penalty doesn't care that the numbers were small. If the entity is truly dormant or winding down, talk through whether a final return should be filed.

How much does professional preparation cost?

It varies with complexity — number of partners, states, and the condition of the books. Our pricing page lays out WAYG's flat-fee ranges so there's no mystery invoice at the end.

Reviewed by the WAYG tax team · Updated July 2026