19.3 Partnership and S Corporation Returns

Partnerships and S corporations are pass-through entities with unique tax treatments. While partnerships avoid entity-level taxes, S corporations may face certain entity-level taxes. Both file specific forms and issue Schedule K-1s to report each owner's share of income and deductions.

Understanding these entities is crucial for income tax return preparation. The flow-through nature of income, deductions, and credits impacts individual tax returns. Partners and shareholders must navigate complex rules regarding income reporting, loss limitations, and potential state tax obligations.

Partnership vs S Corporation Taxation

Entity Structure and Taxation Basics

• Partnerships and S corporations function as pass-through entities with distinct tax treatments under the Internal Revenue Code
• Partnerships avoid entity-level taxation, while S corporations may face certain entity-level taxes (built-in gains tax, excess net passive income tax)
• S corporations have stricter eligibility requirements, limiting number and type of shareholders
• Partnerships offer more flexibility in ownership structure

Reporting and Allocation Differences

• Partnerships file Form 1065 and issue Schedule K-1 to partners
• S corporations file Form 1120S and issue Schedule K-1 to shareholders
• Partnerships can make special allocations of income and deductions among partners
• S corporations must allocate items proportionally based on stock ownership
• S corporations must pay reasonable compensation to shareholder-employees
• Partnerships have more flexibility in compensating partners through guaranteed payments or distributive shares

Examples of Entity-Specific Tax Considerations

• Partnership special allocation (ABC Partnership allocates 60% of profits to Partner A, 30% to Partner B, and 10% to Partner C, despite equal ownership)
• S corporation shareholder compensation (XYZ Inc. must pay CEO-shareholder Jane $150,000 salary for services rendered, in addition to her share of company profits)

Forms and Schedules for Partnership and S Corporation Returns

Primary Tax Forms

• Form 1065 serves as the primary tax return for partnerships and LLCs taxed as partnerships
• Form 1120S functions as the main tax return for S corporations
• Schedule K-1 (Form 1065 or Form 1120S) reports each partner's or shareholder's share of income, deductions, credits, and other items
• Form 7004 requests an automatic extension of time to file business income tax returns for both entity types

Entity Classification and Election Forms

• Form 8832 allows eligible entities to elect their tax classification, including partnership status
• Form 2553 facilitates the election of S corporation status
• Examples:
  • LLC using Form 8832 to elect partnership taxation
  • Small corporation filing Form 2553 to become an S corporation

Supplementary Schedules and Reconciliations

• Schedule M-1 or M-3 reconciles book income to tax income for both partnerships and S corporations
• Additional forms may be required for specific situations (Schedule L for balance sheets, Schedule M-2 for analysis of partners' capital accounts)

Income Flow-Through for Partnerships and S Corporations

Pass-Through Mechanics

• Pass-through entities avoid entity-level taxation
• Income, deductions, and credits "flow through" to owners' individual tax returns
• Partnership income reported on Schedule K-1 (Form 1065) flows to partners' Form 1040 via Schedule E
• S corporation income reported on Schedule K-1 (Form 1120S) flows to shareholders' Form 1040 via Schedule E

Character and Limitations of Passed-Through Items

• Separately stated items (capital gains, charitable contributions, foreign taxes) retain their character when passed through
• At-risk rules and passive activity loss limitations may restrict partners' or shareholders' ability to deduct losses
• Examples:
  • Partner receives $10,000 in long-term capital gains from partnership, reported as such on individual return
  • Shareholder's $20,000 loss from S corporation limited to$15,000 due to basis limitations

Tax Implications for Partners and Shareholders

• Partners and S corporation shareholders generally pay self-employment tax or additional Medicare tax on their share of income
• Exceptions and limitations apply to self-employment tax calculations
• Qualified business income (QBI) deduction under Section 199A may apply to eligible income, potentially reducing individual taxable income

Impact on Individual Tax Returns

Reporting on Individual Returns

• Partners and S corporation shareholders report entity income on Schedule E of Form 1040
• Passed-through income affects adjusted gross income (AGI) and taxable income
• Character of income (ordinary income, capital gains, qualified dividends) impacts individual tax liability and applicable rates

Loss Limitations and Tax Planning

• Losses from partnerships or S corporations may face limitations based on partner's or shareholder's basis, at-risk amount, and passive activity rules
• Partners may need to make quarterly estimated tax payments based on partnership income share
• S corporation shareholders report W-2 wages subject to payroll taxes, in addition to pass-through income

State Tax Considerations

• State tax implications vary for partners and shareholders
• Some states require nonresident returns based on entity's activities in those states
• Examples:
  • Partner in multistate partnership filing nonresident returns in 5 different states
  • S corporation shareholder paying state taxes on business conducted in neighboring state