Income from Partnerships, LLCs, and S Corporations

A partnership is not a taxable business entity, but while it generally pays no tax on its income, it must file a tax return with the government on Form 1065, U.S. Partnership Return of Income. As part of the Form 1065, it will include a Schedule K-1 for each partner showing his or her share of all partnership tax items. The partner then must report these items on the appropriate line of his or her tax return, generally in Part II of Schedule E.

Limited liability companies (LLCs) with multiple owners are treated as if they were partnerships under federal tax law, so they will also file for 1065 and give each LLC member a copy of his or her Schedule K-1.

Warning While the partnership will report your share of any partnership losses on your K-1, you might not be able to deduct them all. Your deductions are generally limited to your tax basis: the amount you have invested in the partnership, plus your share of any partnership liabilities, net income or gains, and minus previous distributions to you. The partnership isn't responsible for keeping track of your tax basis as time passes; you are. However, the K-1s you receive over the years will generally provide a good foundation for your records.

S corporations may have to pay some tax in certain circumstances. For the most part, however, they follow the partnership pattern of passing through most items of income, deductions, credit, etc., to the shareholders through a K-1 form. The shareholders report these items on their own Form 1040, generally in Part II of Schedule E.

Passive activities. If you own a partnership, LLC or S corporation interest that is classified as a passive activity and you have losses for the year, you will have to complete Form 8582, Passive Activity Loss Limitations, to compute your allowable passive losses. Generally passive losses are allowed only to the extent that you have passive income for the year. Any amounts that are disallowed are generally deductible in full in the year you dispose of the activity. For more information, see IRS Publication 925, Passive Activity and At-Risk Rules, which can be obtained for free by calling 1-800-TAX-FORM or by accessing the IRS website.