Two or more owners working together default to partnership taxation: the entity files an information return (Form 1065) and issues each owner a Schedule K-1. An LLC with multiple members is taxed the same way unless it affirmatively elects otherwise. The partnership itself pays no federal income tax; every dollar of income, gain, loss, and credit flows through to the partners on the K-1 and lands on their personal returns. The active share is subject to self-employment tax in the partners’ hands; the passive share is not. That summary hides where the planning lives. Three pieces of partnership mechanics are worth internalizing before you sign an operating agreement:
Capital vs. profits interests. A capital interest is a stake in the partnership’s existing equity — on day one, if the partnership liquidated, the holder would receive a share of assets. Receiving a capital interest in exchange for services is immediately taxable at FMV under IRC §83. A profits interest, by contrast, entitles the holder to a share of future appreciation and income only, with zero value on a hypothetical day-one liquidation. Under Rev. Proc. 93-27 and 2001-43, a properly structured profits interest is not taxable on grant, even when received for services — the most important sweat-equity tool in the partnership tax architecture. The entitlement must be future-only; granting a “profits interest” with any current liquidation value collapses it back into a taxable capital interest. Profits interests are ubiquitous in private equity, hedge funds, and real-estate partnerships precisely because of this rule.
Special allocations and substantial economic effect. A partnership can allocate income and loss disproportionately to ownership percentages — a 90/10 partnership can allocate first-year losses 99/1, then flip to 50/50 after capital is returned. The allocation is respected for tax purposes if it has substantial economic effect under the regulations to IRC §704(b), “Determination of distributive share”, which roughly requires that the allocation actually drive cash distributions on liquidation. Get the operating-agreement language right and the IRS will respect the allocation; get it wrong and the allocations are reallocated by ownership percentage, often unwinding the entire deal’s economics. This is one of the few areas where saving on legal fees costs orders of magnitude more in tax.
Basis tracking is yours, not the partnership’s. Each partner has two basis numbers: outside basis (what the partner paid plus their share of partnership debt plus their share of taxable income, less distributions and losses) and inside basis (what the partnership carries the assets at, allocated among partners). A loss can only be deducted up to outside basis; above that, the loss suspends until basis is restored. The partnership reports your share of income, deductions, distributions, and debt — but you are responsible for tracking your own basis on each year’s return. Most partners never do, and discover the gap only when they sell their interest. Use a separate worksheet; never rely on the K-1 alone. The Section 754 election (section “Section 754 Election and Partnership Inside-Basis Step-Up”) is the relief valve for buyers of existing partnership interests.
Form 1065 and what the partnership actually files. The partnership files Form 1065 by the 15th day of the third month after year-end — March 15 for a calendar-year partnership, a month ahead of the personal deadline so partners have their K-1s in hand — and it is an information return: it reports the partnership’s income and how that income is divided, but carries no tax of its own. Two line items on the K-1 trip up new partners. Guaranteed payments under IRC §707(c) — fixed amounts paid to a partner for services or for the use of capital, regardless of whether the partnership turned a profit — are deductible to the partnership, ordinary income to the partner, and subject to self-employment tax; they are the partnership world’s substitute for a salary, because a partner cannot be a W-2 employee of their own partnership. And the general-versus-limited distinction governs self-employment tax: a general partner’s entire distributive share is self-employment income, while a limited partner’s share generally is not — a line the IRS has been contesting aggressively against fund managers who claim limited status while working full-time in the business.
The audit regime nobody reads until it bites. Since 2018, partnerships are examined under the centralized regime of the Bipartisan Budget Act ( IRC §§6221–6241): the IRS audits the partnership and, by default, collects any resulting tax from the partnership itself at the highest individual rate — meaning today’s partners can bear tax on a prior year’s understatement they never shared in. Two elections soften it. A partnership with 100 or fewer eligible partners can elect out entirely each year on a timely Form 1065, and any partnership can make a “push-out” election under IRC §6226 to shift the adjustment back to the partners who were in during the reviewed year. Name a capable partnership representative in the operating agreement — this person binds every partner in an audit, with no statutory duty to consult them — and address both elections explicitly rather than discovering the default the hard way.
Buying a partnership instead of forming one. You can own partnership economics without ever signing an operating agreement by buying a publicly traded partnership on an exchange, the master limited partnership in energy and infrastructure being the common case. You get a K-1 instead of a 1099, the same basis-tracking burden, passive-loss limits applied separately per-PTP under IRC §469(k), and a potential UBTI problem if you hold one inside an IRA. The full investor’s treatment is in section “Master Limited Partnerships (MLPs)”.
A multi-member LLC’s operating agreement should specify, at minimum, the ownership percentages, any special allocations, the rules for capital calls and distributions, the buy-sell provisions, and dispute-resolution mechanics. Pay a lawyer who actually drafts these to write the first version; the boilerplate that comes out of incorporation services is worse than nothing.