Summary of Federal Income Taxation of Partnerships

Entity Classification.

A Partnership or LLC can elect partnership tax status on the Entity Classification Form 8832. The only time that the Entity Classification selection is not available is if the number of partners is excessive, and that the partnership interests are widely held and deemed to be "publicly traded" pursuant to IRC 7704.

Pass-Through Entity.

A Partnership is a pass-through entity whereby the income, gains, losses, deductions, and credits of the partnership are passed through to the individual partners. The individual partner's tax basis in the partnership is increased by partnership income and gain and reduced by the partnership's share of losses and deductions. Distributions also reduce the partner is tax basis in the partnership interest. Cash distributions in excess of the partner's basis result in taxable gain to the partner. Please see IRC Sections 701-777.

The reason why pass-through entities have an advantage is that businesses typically lose money in the early years, and these losses can be directly passed through to the individual shareholders for deductions on their individual return. Further, the pass-through items from the partnership retain their character. That means that capital gain would pass through to the shareholder rather than as ordinary income which would be the case of a "C" Corporation. The character of tax exempt income is also passed through and retains its tax exempt character in the hands of the partner.