A partnership firm’s income tax calculation runs in two stages, and a worked example is the fastest way to see it: the partnership computes its income on Form 1065 and reports each partner’s share on a Schedule K-1, then each partner pays the actual tax on their own Form 1040. The firm itself owes no federal income tax.1Office of the Law Revision Counsel. 26 USC 701 – Partners, Not Partnership, Subject to Tax What the partners owe, though, stacks in layers: ordinary income tax, self-employment tax, and possibly an additional Medicare tax, offset in part by the qualified business income deduction. The example below walks a two-partner firm through every line.
How the Pass-Through Mechanism Works
The partnership files Form 1065 as an information return. It reports total revenue, deductions, gains, and losses, but produces no tax bill of its own.2Internal Revenue Service. About Form 1065, U.S. Return of Partnership Income Alongside the 1065, the partnership prepares a Schedule K-1 for each partner listing that partner’s individual share of every income and deduction item.3Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065)
The partnership agreement controls how income is split. If it says 60/40, that governs no matter how much cash each partner actually withdrew. Partners owe tax on their full distributive share whether it was distributed to them or not.3Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) This surprises new partners. You can owe a five-figure tax bill on income still sitting in the partnership’s bank account.
Some items also keep their character on the way through. Capital gains, rental income, charitable contributions, and interest income each pass through separately, because their tax treatment depends on the individual partner’s return. A capital gain stays a capital gain; a charitable contribution is subject to the partner’s own percentage-of-AGI limits.
What the Partnership Deducts Before Anything Flows Through
On Form 1065, the partnership subtracts its ordinary and necessary business expenses: rent, utilities, employee wages, insurance premiums, office supplies, professional fees, marketing. The resulting ordinary business income or loss appears on Line 22.4Internal Revenue Service. Form 1065 – U.S. Return of Partnership Income That figure is what gets split among the partners on their K-1s.
Guaranteed Payments to Partners
When a partner receives a fixed payment for services or use of capital regardless of whether the firm makes a profit, it’s a guaranteed payment under IRC Section 707(c).5Office of the Law Revision Counsel. 26 U.S. Code 707 – Transactions Between Partner and Partnership Treat it like a salary-style arrangement. If Partner A manages the business and takes $10,000 a month regardless of results, that $120,000 is a guaranteed payment.
The partnership deducts guaranteed payments on Form 1065, which reduces the ordinary income flowing to everyone. The receiving partner picks up the payment as ordinary income on top of their distributive share. Guaranteed payments are always subject to self-employment tax for the recipient, and they do not count as qualified business income for the Section 199A deduction.
Worked Example: A Two-Partner Firm
Assume a two-person general partnership, split 50/50. Partner A runs day-to-day operations and receives a $120,000 annual guaranteed payment. Partner B is active in the business but takes no guaranteed payment.
Step 1: Partnership-Level Math
- Gross revenue: $600,000
- Operating expenses (rent, payroll, supplies, etc.): $200,000
- Guaranteed payment to Partner A: $120,000
- Ordinary business income after all deductions: $600,000 − $200,000 − $120,000 = $280,000
The $280,000 flows through 50/50. Each partner’s K-1 reports $140,000 in ordinary business income. Partner A’s K-1 also separately reports the $120,000 guaranteed payment.
Step 2: Partner A’s Return
Partner A’s total partnership income is $260,000: the $120,000 guaranteed payment plus the $140,000 distributive share. Assume Partner A is single with no other income.
Self-employment tax comes first. Because Partner A is a general partner, the entire $260,000 is subject to SE tax. Multiply by 92.35% to get the taxable base of $240,110.
- Social Security (12.4%): applies only up to the 2026 wage base of $184,500, so $22,8786Social Security Administration. Contribution and Benefit Base
- Medicare (2.9%): applies to the full $240,110, so $6,963
- Additional Medicare (0.9%): applies to net SE earnings above $200,000 for a single filer, so 0.9% × $40,110 = $361
- Total self-employment tax: $30,202
Partner A deducts half of the regular SE tax (not the additional Medicare portion) as an above-the-line adjustment. Half of ($22,878 + $6,963) is $14,921, reducing AGI to roughly $245,079.
Next, the qualified business income deduction. Partner A’s $140,000 distributive share qualifies for the 20% Section 199A deduction, assuming the firm is not in a specified service field. The $120,000 guaranteed payment does not qualify. That produces a $28,000 deduction.7Internal Revenue Service. Qualified Business Income Deduction
After subtracting the standard deduction and the $28,000 QBI deduction from AGI, Partner A applies the 2026 marginal brackets, which range from 10% to 37%. On roughly $200,000 of taxable income, a single filer owes approximately $40,000 to $42,000 in federal income tax, depending on the exact standard deduction figure.
Partner A’s total federal bill: roughly $70,000 to $72,000, combining income tax and self-employment tax.
Step 3: Partner B’s Return
Partner B received no guaranteed payment, so total partnership income is $140,000. The SE base is $140,000 × 92.35% = $129,290. That falls below the $184,500 Social Security wage base, so all of it is subject to both the 12.4% Social Security and 2.9% Medicare portions: roughly $19,798 in self-employment tax. Income tax is then computed on the remaining taxable income after the above-the-line SE deduction, standard deduction, and a $28,000 QBI deduction on the full $140,000 share.
Self-Employment Tax, in More Detail
SE tax is the biggest surprise for new partners. W-2 employees split payroll taxes with their employer; partners pay both halves. That’s 12.4% for Social Security up to the $184,500 wage base in 2026, plus 2.9% for Medicare on all net SE earnings.6Social Security Administration. Contribution and Benefit Base Single filers with net SE earnings above $200,000, or joint filers above $250,000, also owe an additional 0.9% Medicare tax on the excess.
General partners owe SE tax on the entire distributive share plus any guaranteed payments. Limited partners get a break: under IRC Section 1402(a)(13), a limited partner’s distributive share is generally excluded from SE income, though guaranteed payments for services remain taxable. Who counts as a “limited partner” for this purpose has been contested, and the IRS never finalized proposed regulations on the question. If you actively run the business, plan on paying SE tax on your share regardless of your title.
The Qualified Business Income Deduction
Partners in qualifying businesses can deduct up to 20% of qualified business income under Section 199A. The deduction reduces taxable income but does not reduce SE tax.7Internal Revenue Service. Qualified Business Income Deduction It flows at the partner level, not the partnership level. Only the partner’s share of the partnership’s ordinary business income counts. Guaranteed payments, capital gains, interest, and dividends do not.
Income limits apply. For 2026, the phase-out begins at $201,750 for single filers and $403,500 for joint filers. Above those thresholds, the deduction may be reduced based on the W-2 wages the partnership pays and the depreciable property it owns. Partners in specified service fields, including healthcare, law, accounting, consulting, and financial services, face steeper restrictions and lose the deduction entirely once taxable income exceeds $276,750 (single) or $553,500 (joint).
Below the phase-out, the math is simple: take K-1 ordinary business income, multiply by 20%, deduct the result on the 1040. No itemizing.
When the Partnership Loses Money
Losses pass through the same way income does, but three sets of rules can block a partner from using them right away. They apply in order.
Basis Limitation
A partner can only deduct losses up to their adjusted basis in the partnership interest. Basis starts with what you contributed (cash plus the fair market value of property) and rises with your share of partnership income and additional contributions. It falls with distributions and losses already claimed. Losses in excess of basis suspend and carry forward until basis is restored.8Office of the Law Revision Counsel. 26 U.S. Code 704 – Partner’s Distributive Share
At-Risk Rules
Even with sufficient basis, losses are further limited to the amount you’re personally at risk for. Your at-risk amount generally includes cash invested and your share of partnership debts you’re personally liable on. Nonrecourse debt (where the lender can look only to partnership property) generally doesn’t increase your at-risk amount, with a narrow exception for certain real estate financing.
Passive Activity Rules
Losses from a partnership activity in which you don’t materially participate are passive. Passive losses can offset passive income only, not wages, interest, or portfolio income.9Internal Revenue Service. Topic No. 425, Passive Activities – Losses and Credits If you materially participate, meaning your involvement is regular, continuous, and substantial, the activity is not passive and losses can offset other income (still subject to basis and at-risk).10Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules
Rental real estate has a specific carve-out: if you actively participate, you can deduct up to $25,000 of passive rental losses against non-passive income, phased out as modified AGI rises above $100,000.10Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules Losses blocked under any of these three rules aren’t lost. They carry forward and free up when basis increases, at-risk amount grows, passive income appears, or the partner disposes of the entire interest in a taxable transaction.
Filing Deadlines, Estimated Tax, and Penalties
Form 1065 is due March 15 for a calendar-year partnership (the 15th day of the third month after year-end). Form 7004 gets an automatic six-month extension to September 15.11Internal Revenue Service. Publication 509 (2026), Tax Calendars Schedule K-1s are due to the partners by the same March 15 date so they can prepare their own returns.
Late filing costs $255 per partner per month or partial month, for up to 12 months.12Internal Revenue Service. Failure to File Penalty A five-partner firm three months late faces a $3,825 penalty before anyone looks at the tax numbers. The penalty is waived only for reasonable cause.13Office of the Law Revision Counsel. 26 USC 6698 – Failure to File Partnership Return
Partners are individually responsible for quarterly estimated tax payments on their share of partnership income using Form 1040-ES. The partnership doesn’t withhold on distributions the way an employer withholds on paychecks.14Internal Revenue Service. Businesses 1 – Estimated Tax FAQ Underpaying triggers its own separate penalty. Partners joining a profitable firm mid-year should start estimated payments right away rather than wait until the following April.
State Pass-Through Entity Taxes
Many states now offer an optional pass-through entity tax that lets the partnership itself pay state income tax at the entity level. Treasury approved these regimes in 2020, and they’ve become a common workaround for the $10,000 federal cap on individual state and local tax deductions. The partnership claims the state tax as a federal deduction on Form 1065, effectively bypassing the SALT cap that would otherwise limit the partners’ individual deductions. Rates and rules vary significantly by state, and the election is generally made annually. Not every state offers it, and the mechanics differ enough that partners operating or residing across multiple states should review each state’s rules before making the election.