Partnership taxation basics

Once your LLC has more than one member, you are in partnership tax, and it is a genuinely different system from the disregarded single-member world. It is also the machinery almost no competitor explains well, which is why it is the flagship of this pillar. Get the basics here, and the harder pages on allocations, basis, and the 754 election have somewhere to stand.

Pass-through, and the cash trap

A partnership does not pay income tax. It is a pass-through: it calculates its income, then passes each member their share on a Schedule K-1, and the members pay the tax on their own returns. The partnership itself files an information return, Form 1065, but writes no check to the IRS.

Here is the part that surprises new partners. You are taxed on your share of the partnership’s income whether or not the partnership actually distributes any cash to you. If the LLC earns $100,000 and reinvests all of it, and your share is 50%, you owe tax on $50,000 you never received. Partnership income is taxed as it is earned and allocated, not as it is paid out. This is the single most common shock in partnership taxation, and it is why operating agreements often include tax-distribution clauses that force at least enough cash out to cover the members’ tax bills.

In a partnership you are taxed on your allocated share of income, even if no cash was distributed to you that year.

Outside basis, the number that controls your losses

Every partner has an “outside basis,” their tax investment in the partnership interest. It is not decoration; it is the ceiling on the losses you are allowed to deduct. You cannot deduct partnership losses beyond your basis. Losses that exceed it are suspended until your basis rises again.

Outside basis goes up with the money and property you contribute, with your share of the partnership’s income, and, importantly for real estate, with your share of the partnership’s debt. It goes down with distributions, with your share of losses, and with debt reductions. The reason real estate partners care so much about basis is the debt piece: because your share of the LLC’s mortgage lifts your basis, it lifts how much depreciation loss you can actually use, including the outsized losses a cost-segregation study produces. Basis is the hinge between a big paper loss and a deductible one.

Your outside basis caps the losses you can deduct, and in real estate your share of the mortgage is what keeps that basis high enough to use them.

Why partnership tax is worth the complexity

The reason investors accept all this machinery is flexibility that no other pass-through offers. A partnership can allocate income and loss in ways that do not track ownership percentages. Contribute more cash and you can take more of the early losses; contribute the work and you can take a promote on the back end. A partnership can make guaranteed payments to a member for services or capital, separate from their profit share. It can run distribution waterfalls that pay members in a set order. None of this exists in a disregarded entity or, in the same form, an S-corp. It is the entire reason serious real estate deals, syndications especially, are structured as partnerships.

Each of those tools has its own page ahead: special allocations and the substantial-economic-effect rules that keep them valid, guaranteed payments, capital accounts, and the 754 election that steps up basis when interests change hands. This page is the trunk; those are the branches.

Partnership taxation is complex because it is flexible, and that flexibility, allocating away from ownership percentages, is exactly what sophisticated real estate deals need.

The bottom line

• A partnership pays no tax itself; income passes through to members on K-1s.
• You are taxed on your allocated share even if no cash is distributed to you.
• Your outside basis caps your deductible losses, and partnership debt lifts that basis.
• Partnership taxation allows allocations, guaranteed payments, and waterfalls that track deals, not ownership percentages.
• That flexibility is why syndications and serious real estate partnerships use it, and why it needs careful drafting.

For whether to be a partnership at all, read single-member vs multi-member, the tax view. For syndication structures built on this, see the syndication LLC page. For the full picture, start at the entity and LLC tax strategies hub.

Last verified August 2026.