Part 1: Partnership Taxation Basics — Form 1065, K-1, and K-2/K-3 Explained (2025)

Partnership Taxation Basics — Form 1065, K-1, and K-2/K-3 Explained (2025)

A partnership does not pay tax at the entity level. Instead, it passes through income, deductions, and credits to the partners.
That is why Form 1065 is an informational return rather than a tax-paying return, and each partner receives a Schedule K-1 showing their share.
For 2025, reporting of international items via Schedules K-2 and K-3 is more structured, and IRC §1061 (the 3-year carried-interest rule) remains a key compliance topic for funds and investment partnerships.

1) Pass-Through Structure

Partnerships are pass-through entities: the entity files Form 1065 to report activity, while partners pay the tax on their allocations.
Allocations are typically reported on a partner’s Form 1040, Schedule E.
Even if cash is retained in the entity, tax follows the allocation, not the distribution.

2) Key Forms: 1065, K-1, K-2/K-3

• Form 1065 — Annual return reporting the partnership’s income, deductions, and credits. Due March 15 (extension available).
• Schedule K-1 — Statement to each partner of their share of items for their personal return.
• Schedules K-2/K-3 — Structured reporting for foreign items (e.g., foreign-source income, FTC, treaty positions).
  If a partner requests K-3 information at least one month before the deadline, the partnership generally must file K-2/K-3 and provide K-3 to that partner.

3) Common Misunderstandings

• “The partnership pays the tax.” — No; partners do.
• “No cash, no tax.” — Incorrect. Tax is based on allocations, not cash distributions.
• “Guaranteed payments are just allocations.” — No. They are deductible to the partnership and ordinary income to the recipient partner.
• “Securities distributions are always tax-free.” — Not always; §731(c) may treat certain marketable securities as cash equivalents.
• “Carried interest is long-term after one year.” — §1061 generally requires a 3-year holding period for applicable partnership interests.

4) Example: Unequal Ownership Scenario

5) 2025 Practice Checklist

• File K-2/K-3 when foreign items exist or upon a timely partner request.
• Record guaranteed payments as a partnership deduction and partner ordinary income (health-premium equivalents may apply).
• If distributions exceed a partner’s basis, recognize capital gain.
• Check §731(c) before distributing marketable securities.
• Review carried-interest structures for §1061 (3-year rule) compliance.

6) Further Reading & Internal Links

• External:
IRS — About Form 1065 ·
Form 1065 Instructions ·
Publication 541 — Partnerships ·
Section 1061 FAQs

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