Partnership Loss Limitations

Deductible Losses Cannot Exceed Your Partnership Basis

Your deductible share of partnership losses may not exceed the “adjusted basis” in your partnership interest.  If your share of the loss exceeds your basis [essentially your net investment-to-date, plus your share of partnership earnings (or minus your share of partnership losses), minus your withdrawals from the partnership], the excess loss amount may not be deducted until you have additional partnership earnings or make additional capital contributions sufficient to cover the excess loss (in the subsequent year(s)).  A partner will also have basis for loans made to the partnership for which he or she is personally liable.


Year 1

Jim is a 25% partner in the PJQ Partnership.  In Year 1, he invests $5,000 for his partnership interest.   His share of the partnership loss in Year 1 is $2,500 and he withdrew $1,000 from the partnership in Year 1 for personal expenses (this is considered a “distribution” to Jim).  His adjusted basis at the end of Year 1 would be $1,500 ($5,000-$2,500-$1,000).  Since he still has a positive adjusted basis at the end of Year 1, he would be allowed to deduct the full $2,500 loss on his personal return (taken from the Form 1065 K-1 he receives from the partnership).

Year 2

In Year 2, Jim is still a 25% partner.  He adds an additional $1,000 to his capital investment account during the year and makes no withdrawals.  At the end of Year 2, Jim’s share of the partnership loss is $3,000.  At the end of Year 1, Jim had adjusted basis of $1,500 (which carried forward to the beginning of Year 2) plus he added $1,000 to his capital investment, giving him an adjusted basis of $2,500 before he deducts his share of the Year 2 loss of $3,000.   Since his share of the loss exceeds his adjusted basis by $500 ($2,500-$3,000), he can only deduct the amount of the loss that brings his basis down to zero, or $2,500, on his personal return for Year 2.   The remaining $500 loss is disallowed for the current year and carried forward to subsequent tax years until Jim’s basis has been restored (by additional capital contributions and/or his share of partnership profits) to cover the loss.

The above example represents the fundamental changes in a partner’s interest in a partnership.  There will be other adjustments to each partner’s basis depending on the activities of the partnership and the activities of each partner during the year.

It is absolutely essential that each partner keep track of his or her basis adjustments each year, beginning in Year 1, and until the partnership is either dissolved or the partner terminates his or her interest in the partnership.  The burden is on the partner (“taxpayer”) to substantiate his or her basis at the end of each year that he or she is active in the partnership (your documented partner basis history).  If your return is selected for examination by the IRS and you have deducted partnership losses, you WILL be asked for your basis calculation history to substantiate the loss.

Usually, if you are invested in a partnership, you will have retained a competent tax advisor who will prepare each year’s basis documentation and who will also maintain a complete history of your investment in the partnership.  This history is also very important if you wish to terminate your interest in an on-going partnership or when the partnership is dissolved.

It was my experience, as an IRS auditor, that well over 50% of “small” business partnership (defined as less than $10 million in assets) investors had either no documentation or incomplete documentation regarding their basis.   Without this substantiation [including very credible (and expensive) reconstructions], partner losses taken on the examined personal returns were disallowed.

Best advice:  track your partnership basis from day one until you leave the partnership or it dissolves.

Reporting Partnership Profit and Loss

Shaking hands symbolThis blog is primarily focused on sole proprietors.  However, there are occasions when writers, authors, illustrators and literary agents will want to form a partnership for a one-time event or for a specific set of activities when additional talent (and investment) are needed to provide a synergistic result.   For that reason, I will post some key information regarding partnership accounting and taxation.

First, and foremost, you need a written partnership agreement that covers the role and responsibility of each partner.  There are numerous issues to cover regarding the management of the partnership as well as the profit/loss allocation formula to each partner that should be covered in the partnership agreement.  You will want to engage an attorney to prepare this document for your specific circumstances and avoid “instant online partnership agreements” where one-size does not fit all. You should also have your personal attorney review the document before you sign it.  He or she can explain any part of the agreement you do not fully understand before you sign it.

Reporting Partnership Profit and Loss

A partnership files Form 1065.   Form 1065 reports the overall partnership profit or loss and also each partner’s share of that profit/loss using attached Schedule K-1 forms (copies of the Schedule K-1 are also sent to each partner to report their share on their personal return). The partnership pays no tax on partnership income at the partnership level; each partner reports his or her share of partnership profit or loss and special deductions and credits and any distributions received from the partnership (if any), as shown on Schedule K-1.

Each partner will report his or her share of the partnership profit or loss for the partnership year that ends in their tax reporting year.  If the partner and the partnership are on a calendar-year basis, the partner reports his or her share of the 2012 partnership profit or loss on their 2012 personal income tax return.  If the partnership is on a fiscal year ending June 30, for example, and the partner reports on a calendar year, the partner reports on his or her 2012 return their share of the partnership profit or loss for the whole fiscal year ended June 30, 2012–that is, partnership profit or loss for the fiscal year July 1, 2011 through June 30, 2012.

Health Insurance Premiums

A partnership that pays premiums for health insurance for partners has a choice.  It may treat the premium as a reduction in distributions to the partners.  Alternatively, it may deduct the premium as an expense and charge each partner’s share as a guaranteed salary payment taxable to the partner.  The partner reports the guaranteed payment shown on Schedule K-1 as nonpassive income on Schedule E and may deduct 100% of the premium on Line 29, Form 1040, as an above-the-line deduction from gross income.

Guaranteed Salary

A guaranteed salary that is fixed without regard to partnership income is taxable as ordinary wages and not as partnership earnings.

Self-Employment Tax

As a general partner, you pay self-employment tax on your net partnership income, including guaranteed salary and other guaranteed payments.   Limited partners do not pay self-employment tax, unless guaranteed payments are received.