Tax Treatment of Partnerships
Since the partnership is a “pass through” entity, there is no potential for income tax on it. Unlike corporations and irrevocable trusts, a partnership is not a taxpaying entity. A partnership files an annual informational tax return setting forth its income and expenses, but it doesn’t pay tax on its net income. Instead, each partner’s proportionate share of income or loss is passed through from the partnership to the individual. Each partner claims his share of deductions or reports his share of income on his own tax return.
This avoids the potential for double taxation that is always present in a C Corporation. Typically, when a business is expected to show a net loss rather than a gain, the partnership format is used so that the losses can be used by the partners. Limited partnerships have always been used for real estate and tax shelter investments in order to pass the tax deductions through to the individual investors. These losses are then used by the partner to offset other income he might have. Although the Tax Reform Act of 1986 now limits the ability to immediately deduct losses from “passive activities” to offset wages or investment income, the partnership format may still be desirable if the circumstances of the individual partner are such that he is able to take advantage of these losses.
The rules regarding the taxation of partnership activities are lengthy and cumbersome. As a general rule, however, transfers of property into and out of a partnership will not ordinarily produce any tax consequences.