Partnerships themselves do not pay income tax. Instead, profits and losses from the partnership are passed through to the partners, who pay the taxes at the individual level. Since partners pay taxes on their share of partnership income, they aren't taxed when they receive a withdrawal or distribution – as long as the distribution doesn't exceed their basis.
Take a look at what you should know about the Schedule K-1 tax form and to understand how taxation works for partners both when the distribution does and doesn't exceed the partner's basis.
About Schedule K-1
Schedule K-1 is a tax form that a partnership generates to report a partner's share of income, deductions, credits and distributions and other relevant information. Part I of this tax form includes some basic information about the partnership, while Part II has details for the specific partner such as their share of the profit and liabilities plus their identifying details. Part III goes into detail about their share of the income during the tax year along with the credits and deductions that apply to them.
Some of the details are purely informational, while other details must be carried over to the partner's main Form 1040. The Internal Revenue Service's "Instructions for Schedule K-1" notes which information must be carried over and where it should be listed.
How Partners Are Taxed
Although withdrawals and distributions are noted on the Schedule K-1, they generally aren't considered to be taxable income. Partners are taxed on the net income a partnership earns regardless of whether or not the income is distributed.
For example, say that Partner A has a 50 percent share in a partnership that earned $60,000 in net income during the tax year. At the end of the year, Partner A will receive a Schedule K-1 that shows he had income of $30,000 (50 percent of $60,000) from the partnership, and he'll owe income tax on that amount.
If the partner wants, he can leave that $30,000 in the partnership. The partnership will retain the cash in a business bank account and report it as partner's equity on the balance sheet. Because he was already taxed on the $30,000 of partnership income, he won't be taxed again when he withdraws it.
Exception to the Rule
Withdrawals and distributions aren't taxable as long as they don't exceed the partner's basis. A partner's basis is the amount of money he's put into the partnership plus his share of partnership income and minus his share of partnership losses. If the partner withdraws more than his basis, the difference is taxable income.
For example, say that Partner A had put $10,000 of his own cash into the partnership, and his distributive share of partnership income is $30,000. He can withdraw up to $40,000, and it will not be taxable. If he withdraws $45,000, the excess $5,000 is taxable.
The IRS notes in the Partner's Instructions for Schedule K-1 that the partner is responsible for keeping track of his basis and reporting taxable income.