unlike most business entities such as C or S corporations a partnership is never subject to federal income taxation rather the partners themselves are liable for the income tax under partnerships taxable income with each partner individually taking into account his distributive share of each item including the partnerships income gain deduction loss and credit this makes the partnership a pure pass-through entity with all of its taxable income and loss passing through and being taxed to its owners despite its never being subjected to income tax a partnership must still account for its own gross income deductions etc reporting these annually unformed 1065 entitled us return of partnership income each partners distributive share of these tax items is then reported to the partners and to the IRS on a schedule k-1 the partners in turn recognize their respective shares of these k-1 items on their own returns section 702 a of the Internal Revenue Code lists several items of taxable income and deductions that a partnership must separately state from its bottom line taxable income when reporting its income and loss each year this is because each of these items may be recognized in different ways by different partners partners who are individuals for example will apply the preferential rate on long term capital gains typically 15 or 20 percent whereas partners who are corporations pay the same rate on capital gains as they do on regular profits similarly both individual and corporate taxpayers may reduce their taxable capital gains by taxable losses recognized during the year thus the partnerships capital gains must be separately stated from its ordinary income in order for the partners to properly apply those rules consider for example a partnership with two partners one an individual and the other a corporation during the given taxable year partnership recognizes a 100 dollar capital gain receives $100 in dividends on stock of a corporation raishin that it owns and recognizes an $800 profit on a trade or business activity in which the partnership engages overall partnership has recognized $1,000 in taxable income for the year but it must report each of these items separately to its partners if the $100 capital gain that the partnership recognized is a long-term capital gain then the individual partner will be entitled to apply the preferential capital gains rates on his distributive share of that game similarly if the $100 in dividends are qualified dividends then the individual partner may also be entitled to use the preferential rates for qualified dividends on his distributive share of those dividends on the other hand the $800 in trade or business income may be considered net earnings from self-employment for the individual partner for the individual partner this kind of income is subject not only to income tax under section 1 of the Internal Revenue Code but may also be subject to the self-employment tax imposed by section 1401 for the corporate partner there's no separate rate of tax on ordinary income and capital gain nevertheless the corporate partner may be entitled to apply some capital losses it recognizes from other sources against its distributive share of the partnerships capital gain thus reducing the amount of gross income the corporate partner recognizes overall for the tax year moreover the corporate partner may be entitled to the dividends received deduction under section 243 of the code thus stating separately the corporate partners distributive share of the dividends that the partnership received will enable the corporate partner to properly apply that rule separately stating each item of partnership income deduction gain loss and credits is therefore necessary in order for the partners to properly recognize their respective distributive shares as it is the partners and not the partnership that pays tax on the partnerships income each partner must know his share of each different kind of tax item that the partnership might recognize during a tax year another implication of the separately stated item rule is that the character of each partnership level tax item must be maintained as it passes through to the partners the character of a tax item refers to its specific nature under the Internal Revenue Code that is to say a particular item of income or loss can be ordinary or it can be capital trade or business income it is generally an ordinary item of income whereas the profit on the sale or exchange of a piece of property is generally a capital gain certain other items may have an even more specific character transfers of cash or property to a qualifying charitable organization may be considered a charitable contribution for example which characteristic must be maintained as that deduction is passed through to the partners in order for them to properly account if on their own returns although a partnership is not a taxpayer in the sense that it pays an income tax on its earnings it nevertheless must compute its gross income deductions and its gains and losses as if it were an individual taxpayer before passing those items through to the individual partners under Section 703 a of the code a partnership makes these computations in the same manner as in the case of an individual meaning that whenever the tax Lum poses a different rule on the characterization of a tax item for an individual taxpayer than it does for a corporate taxpayer the partnership uses the individual taxpayer rule take for example the rule for losses at section 165 of the code the general rule is that every taxpayer whether an individual or a corporation is entitled to a deduction for losses sustained during a tax year probably the most attractive aspect of partnerships to taxpayers is the rule of distributive shares under Section 704 a of the code a partner's distributive share of income gain loss deduction or credit shall be determined by the partnership agreements this means that while 100% of a partnership stacks items must be passed through to its partners in one way or another each partners respective share of those items is determined by them or more specifically by whatever agreements whether written or oral that they have made amongst themselves this makes partnerships very flexible in terms of planning for the allocation of tax items among the partners consider the partnership discussed above with the $100 in capital gains $100 in dividends and $800 in trade or business income the two partners one an individual and the other a corporation are by no means required to divide those tax items evenly between them rather each partners distributive share of each of those tax items will be determined by the partners agreements they might agree for example that the individual partner will be allocated 60 percent of the capital gain 70% of the dividends and 80 percent of the trade or business income with the remainder of each item allocable to the corporate partner there is no requirement that this be accomplished by way of percentages either they might instead agree for example that the individual partner will be allocated the first seventy-five dollars of each of these items whatever the amount might be each year with the whole of any remainder being allocated to the corporate partner note too that the partners respective proportions of the partnership ownership or capital are irrelevant to the determination of their distributive shares in each of the allocation schemes described above it doesn't even matter whether the partnerships capital was funded evenly by the two partners or even whether one partner contributed all of the partnerships operating capital the only factor for determining the partners distributive shares is their agreement there are limitations on this flexible allocation rule principle among these limitations is the substantial economic effect rule while the rules nuances are incredibly complex and beyond the scope of this presentation the general rule is that the partners determination of their respective distributive shares need only be respected by taxing authorities insofar as the particular allocation has a real and substantive effect on the partner in other words there has to be some other effect of this distributive share it can't solely be an agreement that's only effect is for tax purposes all in all due to the fact that it's a pass-through entity and because of its tremendous flexibility the partnership represents an entity whose tag treatments can be used favorably by taxpayers