Unlike the rules that apply to C corporations, which tax income both at the entity and at the owner level, the partnership rules are designed to only tax income once, at the owner level.
A partnership’s income, losses, deductions, and credit are passed through to the partners for Federal tax purposes and taxed directly to them, regardless of when income is distributed. Since the partners have already paid tax on the income when it is earned, a complex system of rules applies to prevent double taxation when the income is later distributed to the partners.
Whether earnings are retained in a partnership or distributed to partners has no affect on the taxation of those earnings, since the partners have to pay tax on the earnings whether they are distributed or not.
Earnings are distributed to each partner's capital account from which distributions are charged against.
The Internal Revenue Code uses four tests to make this distinction: To prevent gamesmanship among related parties, Congress has added another layer of rules that must be analyzed to determine if a distribution is a redemption.
These attribution rules provide that shares owned by a shareholder’s parents, children, and grandchildren (but not siblings) are considered to be owned by the shareholder. Similarly, shares held by corporations, trusts, and partnerships are deemed to be owned by their shareholders beneficiaries, and partners, and vice versa. As a result, shares held by these family members and entities are considered to be owned by the shareholder for purposes of determining whether the distribution qualifies as a redemption.
Distributions to the shareholder are not included in the shareholder’s gross income to the extent that the distribution does not exceed the shareholder’s basis in the stock.
Because the tax consequences of distributions depend on the shareholder’s basis, it is important to keep up with changes in the shareholder’s basis over time.
There are 2 types of distributions: a current distribution decreases the partner's capital account without terminating it, whereas a liquidating distribution pays the entire capital account to the partner, thereby eliminating the partner's equity interest in the partnership.The partner’s basis in his partnership interest in increased by: These basis adjustments depend in large part on the allocation of partnership income, gains, losses, deductions, and credit among the partners.The partnership agreement determines the allocation of these items. If the partnership agreement is silent, these items are allocated in accordance with the partnership interests. If the partnership agreement allocates partnership items among the partners, the allocation is respected as long as one of the following is true: If an allocation does not meet one of these requirements, the allocation of income, gain, loss, deduction, or credit is reallocated in accordance with the partner’s interest in the partnership. Special rules apply to allocations of property with built-in gain and loss. Important Note: The rules governing substantial economic effect are complex and must be given special consideration if the partnership agreement or operating agreement provides for allocations other than in accordance with each partner’s interest in the partnership.The shareholder’s basis is decreased (but not below zero) by the shareholder’s share of the S corporation’s items of loss and deduction, nondeductible expenses (except expenses that are not chargeable to the capital account), depletion deduction for oil and gas property, and distributions to the shareholder that are not made from accumulated earnings and profits.This helps ensure that the shareholder only benefits once from reductions in income earned by the S corporation.