Partnership taxation

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Partnerships are "flow-through" entities for United States federal income taxation purposes. In the absence of an election to the contrary, multi-member limited liability companies (LLCs), limited liability partnerships (LLPs) and certain multi-member trusts are treated as partnerships for United States federal income tax purposes. Certain non-U.S. entities may also be eligible for treatment as partnerships. The states of the United States do not universally accord "flow-through" taxation to partnerships, and some distinguish among different kinds of entities that are treated the same under federal tax principles (e.g. Texas taxes LLCs as corporations, while according flow-through treatment to partnerships). Local jurisdictions may also impose their own taxes on entities taxed as partnerships at the federal level (e.g. New York City unincorporated business tax).

Flow-through taxation means that the entity does not pay taxes on its income. Instead, the owners of the entity pay tax on their "distributive share" of the entity's taxable income, even if no funds are distributed by the partnership to the owners. Federal tax law permits the owners of the entity to agree how the income of the entity will be allocated among them, but requires that this allocation reflect the economic reality of their business arrangement, as tested under complicated rules.

Partnership taxation is codified as Subchapter K of Chapter 1 of the U.S. Internal Revenue Code (Title 26 of the United States Code).

The most well recognized authority on this subject was Professor Arthur Willis (deceased), whose work is still being carried on by his legal associates at Northwestern University, They publish "Willis on Taxation", updated annually.

Certain threshold issues bear mentioning here: (1) Members of an LLC or partners of a partnership which has elected to be treated as a partnership by the Internal Revenue Service (IRS) may use a proportionate share of the partnership debt in order to increase their "basis" for the purpose of receiving distributions of both profits and losses; (2) Members and/or partners must be "at risk" pursuant to 26 U.S.C. § 465, and (3) they must actively participate pursuant to 26 U.S.C. § 469.

There is little published authority on these matters, and on the issue of material participation in LLCs there is only the Gregg (U.S.D.C. Oregon 2000) and Asaph cases (U.S. tax Ct. 2005). These cases generally seem to agree that the least onerous test for qualifying for material participation for an LLC member is the same as that for a General Partner in a Limited Partnership, or 100 hours annually.

There have been uncountable volumes published on partnership taxation, and the subject is usually offered through advanced taxation courses in graduate school. The IRS publishes a substantial amount of partnership Rev. Procs. and Rev. Rulings, and both temporary and permanent regulations annually.

While Subchapter K is a small section of the Internal Revenue Code, it is as comprehensive as any other area of business taxation. The recent IRS emphasis to stop abusive tax shelters has brought on an onslaught of regulation, as most abusive shelters utilize partnerships in some form.