Partnership Tax Basics: Form 1065, K-1s, and Basis
How a multi-member LLC or partnership is taxed, what each partner reports, why basis and capital accounts matter, and the audit rules that apply.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A partnership — including a multi-member LLC taxed as one — pays no income tax itself. It files Form 1065 and gives each partner a Schedule K-1 showing their share of income and deductions, reported on their own returns whether or not cash was distributed. Each partner tracks a basis that limits losses and governs distributions.
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How does reporting work?
| Item | Where it goes |
|---|---|
| Partnership income and expenses | Form 1065, due the 15th day of the third month after year-end — March 15 for calendar-year partnerships (six-month extension on Form 7004) |
| Each partner's share | Schedule K-1 (plus Schedule K-3 when the partnership has items of international tax relevance), furnished to each partner by the return's due date, including extensions |
| Partner's tax | Their own Form 1040 or entity return |
| Partner's capital account | Reported on the K-1 on the tax basis method |
The partnership agreement controls how items are allocated, provided the allocations have substantial economic effect. Guaranteed payments for services are ordinary income to the partner and deductible to the partnership.
How is self-employment tax applied?
General partners and most LLC members who work in the business pay self-employment tax on their distributive share and guaranteed payments. Limited partners are exempt on their distributive share, though not on guaranteed payments for services. The Tax Court applies a functional test: an LLC member or limited partner who actively runs the business cannot claim the exemption by title alone (Castigliola, 2017; Soroban Capital Partners, 2023). The Fifth Circuit rejected the Tax Court's passive-investor standard in K Alain, L.L.L.P. v. Commissioner (August 12, 2026, replacing its earlier Sirius Solutions opinion) but still denies the exemption to a partner who plays a significant role in managing or running the business, so the law is unsettled.
On September 17, 2026, the Second Circuit affirmed the Tax Court in Soroban Capital Partners LP v. Commissioner (Nos. 25-2079 and 25-2250), holding that a limited partner for this purpose is one who has limited liability and does not run, manage, or control the partnership's business, so the firm's three principals owed self-employment tax on their distributive shares. The Fifth Circuit's K Alain decision rejected the Tax Court's passive-investor framing and states its own test, so the two circuits approach the question differently, although the Second Circuit observed there may be little practical difference between them. A similar case, Denham Capital Management, is pending in the First Circuit, and further review is possible; until the law settles, a limited partner who works in the business should not assume the exemption applies.
What is a partner's basis?
Outside basis starts with contributions, increases with the partner's share of income and liabilities, and decreases with distributions, losses, and reductions in liability share. Losses are deductible only to basis, with excess carried forward. Distributions of cash above basis are gain. Basis differs from the capital account mainly because of liabilities.
What is a Section 754 election?
When a partner buys an interest or dies, the inside basis of partnership assets does not change by default (unless the partnership has a substantial built-in loss of more than $250,000, which forces a downward adjustment). A Section 754 election lets the partnership adjust basis for that partner, so a buyer who paid for appreciated assets gets depreciation and reduced gain on the share they bought. Once made, the election applies to all later transfers and property distributions, and it can be revoked only with IRS approval.
How are partnerships audited?
Under the centralized audit regime, the IRS audits the partnership and assesses tax at the partnership level in the year the audit concludes, unless the partnership elects out or pushes adjustments out to the partners. Electing out is made each year on a timely filed return (Schedule B-2) and is available only to a partnership that issues 100 or fewer K-1s (counting an S corporation partner's shareholders) and whose partners are all individuals, C corporations, S corporations, eligible foreign entities, or estates of deceased partners — a single partner that is a partnership, trust, or single-member LLC disqualifies it. A partnership that does not elect out names a partnership representative on its return, with sole authority to bind it.
Frequently asked questions
Can a partner be an employee of the partnership?
No. Partners are not employees and cannot receive W-2 wages from the partnership; compensation is a guaranteed payment.
Is a multi-member LLC always a partnership?
By default yes, unless it elects corporate treatment, or it is owned by spouses in a community property state who elect otherwise.
What is the penalty for a late Form 1065?
$255 per partner for each month or part of a month the return is late, for up to 12 months, on returns due in 2026 (rising to $260 for returns due in 2027), with relief available for small partnerships that meet specific conditions and for reasonable cause.
Do partners pay tax on money they did not receive?
Yes. Partners are taxed on their share of income whether or not it was distributed, which is why agreements usually require tax distributions.
Official sources
The IRS explains: “A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" profits or losses to its partners.” — Internal Revenue Service, Partnerships, https://www.irs.gov/businesses/partnerships
The IRS explains: “Generally, a partnership’s basis in its assets is not affected by a transfer of an interest in the partnership, whether by sale or exchange or because of the death of a partner. However, the partnership can elect to make an optional adjustment to basis in the year of transfer.” — Internal Revenue Service, Publication 541 (12/2025), Partnerships, https://www.irs.gov/publications/p541
The Second Circuit held: “Accordingly, we hold that, for the purposes of § 1402(a)(13), a "limited partner" is one who has limited liability and who does not run, manage, or otherwise exert control or managerial authority over the partnership.” — U.S. Court of Appeals for the Second Circuit, Soroban Capital Partners LP v. Commissioner of Internal Revenue, Nos. 25-2079 (L), 25-2250 (CON) (September 17, 2026), https://ww3.ca2.uscourts.gov/decisions/OPN/25-2079_opn.pdf
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Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk prepares partnership returns with tax-basis capital accounts and partner basis schedules kept current. See pricing or book a free fit call.
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