A partnership pays no federal income tax, yet its partners can owe tax on income they never received in cash. That gap between allocation and cash is where most exam questions live.
A partnership files a return, but the income itself is taxed to the partners. The partnership computes its income under IRC 703 and reports it on Form 1065. Every dollar of partnership income then passes to the partners on Schedule K-1, the form that shows each partner's share. A partner reports the allocated share whether or not any cash is paid out.
Partnership income leaves the partnership in two buckets:
- Ordinary business income: Sales, cost of goods sold, wages, rent, and other operating expenses are netted into one number on Form 1065 page 1.
- Separately stated items: Capital gains, IRC 1231 gains, charitable contributions, IRC 179 expense, tax-exempt interest, and credits each pass through in their own K-1 box, because the partner's tax rate...
KEY: Character flows through unchanged. Character is the type of income, such as ordinary income or a long-term capital gain.
Common mistakes
- Adding a guaranteed payment to outside basis. It never increases basis; only the distributive income share does.
- Reducing basis for losses before distributions. Distributions come first, so a $95,000 distribution against $80,000 of basis triggers gain even when losses are still to be deducted.
- Applying the 12.4% Social Security tax above $176,100. Only the 2.9% Medicare rate is uncapped.
Bottom line
- A partnership pays no tax; income, expenses, and credits flow through on Schedule K-1 with character preserved.
- Basis ordering: income up, then distributions down, then losses; basis never goes below zero.
- Cash distributions exceeding outside basis create capital gain; current distributions never create loss.
- A reduction in a partner's share of liabilities is a deemed cash distribution under IRC 752(b).
Exam shortcut
Read the partner's status line first. "General partner" flags Schedule SE on the full ordinary share; "limited partner" narrows self-employment income to guaranteed payments only. When a stem gives a distribution and a loss in the same year, run the order out loud: income, distribution, loss. Candidates who net everything at once pick the wrong basis and miss the gain.
The full lesson (about 2,048 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2
Browse all free EA Part 2 lessons or jump into free EA Part 2 practice questions.