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A partnership is an association of two or more people that pursues some business or financial operation and divides profits among its members. Partnerships are different from C corporations, in that they do not pay taxes. Rather, partners pay the partnership's taxes on their individual returns. Partnerships report income, expenses, credits and dividends on Internal Revenue Service Schedule K-1.
Partnerships don’t issue stock and don’t pay dividends. Both of these activities are reserved for corporations. However, a partnership can make income that it distributes to its partners. Distributions resemble dividends in several ways: They are normally cash payments and may be issued periodically throughout the year. However, they don’t qualify for special tax rates and are treated as ordinary income. Partners report their shares of income, whether or not it’s actually been distributed. Schedule K-1 reports each partner’s share of income. A partner uses this information to complete Schedule E Part II of Form 1040.
Passive vs. Active Income
Schedule E reports passive and active income from partnerships separately. In general, a partner’s income is passive if she doesn't help run the partnership. The distinction is important because active partners pay self-employment tax on their shares of partnership income, but passive partners don’t. Self-employment tax helps pay for Social Security and Medicare. Partners also report passive and active losses separately on Schedule E. Even though partnerships don’t pay taxes, the partners still file tax returns, using Form 1065.
Partnerships may hold property, including stock investments. Partnerships distribute the dividends received on stock holdings to partners. Qualified dividends stem from U.S. corporations that pay taxes on income and from qualified foreign corporations. These dividends are taxed at long-term capital gains rates. Nonqualified dividends count as ordinary income, taxed at the partners’ marginal rates. Schedule K-1 reports qualified and nonqualified dividends. Partners report these dividends directly on Form 1040.
C corporations distribute dividends democratically: The more shares you own, the bigger your dividend check. Partnerships operate under an agreement drawn by the partners that may be anything but democratic; there need not be any direct relationship between a partner’s investment and that partner’s share of income and dividends. Certain partners may receive guaranteed payments whether or not the partnership makes a profit. Schedule K-1 expresses the financial results of a partnership agreement. Specialized partnership structures, such as limited liability corporations and master limited partnerships, also use Schedule K-1 to report income and dividends.
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