Two people start a business together. The IRS calls it a partnership whether they do or not.
It files a return but pays no tax. The partners pay, on income they may never have taken out.
Here is how it works, what the K-1 means, and the one number every partner has to track.
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A partnership is the default tax treatment for any business with more than one owner that hasn’t elected to be a corporation. Two friends who form an LLC for a landscaping company are a partnership for tax purposes the day they open the bank account, even if the word never appears in their paperwork. So are a husband and wife who buy a rental together in an LLC, three doctors who share a practice, and a family that holds the farm in a limited partnership.
The partnership files Form 1065 every year, but it pays no federal income tax. Instead it hands each partner a Schedule K-1 showing that partner’s share of the profit, and the partner pays the tax on a personal return. That one idea, the entity reports and the owners pay, explains almost everything else on this page, including the part that surprises people: you owe tax on your share of the profit whether or not the partnership paid it out to you.
A multi-member LLC is a partnership for federal tax unless it files Form 8832 to be taxed as a C corporation or Form 2553 to be an S corporation. Most don’t, so most two-owner LLCs file a 1065. A single-member LLC is the opposite: it is ignored for tax and its owner files a Schedule C.
Spouses who own a business together and file jointly can elect out of partnership treatment as a qualified joint venture, each filing a Schedule C for their share. The catch in Colorado: that election is not available if the business is held in an LLC, because Colorado is not a community-property state. A husband-and-wife LLC here is a partnership and files a 1065.
Co-owning a rental is not a partnership by itself. Two siblings who inherited a duplex and split the rent can each report their half on Schedule E. It becomes a partnership when they provide services beyond what a landlord normally does, or when they put the property into an LLC together.
Sharing expenses is not a partnership either. Two contractors who split an office and a receptionist but keep separate customers and separate books are two businesses, not one.
↑ Back to topForm 1065 is an information return. It reports the partnership’s income and expenses, computes the profit, and allocates it among the partners. The tax is paid by the partners on their own returns, so the 1065 itself shows no tax due. Every domestic partnership must file one for any year it has income or deductible expenses, even if the profit is zero.
Due date: March 15 for a calendar-year partnership, a month before your personal return. That is on purpose: you need your K-1 before you can file your 1040. An extension (Form 7004) moves the 1065 to September 15, which is why partners in extended partnerships often end up extending their personal returns too.
The penalty for filing late is per partner, per month. For returns due in 2026 it is $255 for each partner for each month or part of a month the return is late, up to 12 months. A three-partner LLC that files its 1065 in July without an extension owes about $3,000 in penalties, on a return with no tax on it. Partnerships with ten or fewer partners, all of them individuals, who each reported their share on time can usually have the penalty waived under an old IRS procedure, but the waiver has to be asked for.
The K-1 is your personal slice of the 1065. It lists your share of ordinary business income, rental income, interest, capital gains, Section 179, guaranteed payments, distributions, and the information you need for self-employment tax and the QBI deduction, each on its own line, because each one goes to a different place on your 1040. You cannot file your personal return correctly without it. If the K-1 is late, your return is late.
↑ Back to topThis is the part that surprises new partners. The partnership earns $120,000 and the two partners each take $30,000 out during the year to live on, leaving $60,000 in the bank for next year’s equipment. Each partner’s K-1 shows $60,000 of income, not $30,000, and each pays tax on $60,000. The money left in the business was still earned, and it was still theirs.
The flip side is that taking money out is generally not a taxable event. A distribution, whether a monthly draw or a year-end lump sum, is tax-free as long as the partner has basis to absorb it (basis is explained below). The income was taxed when it was earned; the distribution is just the partner collecting it.
Your share is set by the partnership agreement. Fifty-fifty is common, but an agreement can allocate profit one way and losses another, or give one partner a preferred return, as long as the allocation has real economic effect and is not just a tax-shifting device. If the agreement is silent, the shares follow the partners’ interests in the partnership.
Certain items are kept separate on the K-1 instead of being folded into ordinary income, because they are treated differently on each partner’s return: capital gains, Section 1231 gains, rental income, interest and dividends, charitable contributions, Section 179 expense, and a few others. A partner in the 12% bracket and a partner in the 35% bracket pay different rates on the same capital gain, so the partnership can’t net it for them.
↑ Back to topA partner cannot be an employee of the partnership. There is no W-2, no withholding, and no payroll. When one partner works full time in the business and the other is an investor, the working partner is usually paid a fixed amount for the work, say $6,000 a month, before the remaining profit is split. That fixed amount is a guaranteed payment: it is set without regard to how much the partnership earns.
To the partnership, a guaranteed payment is a deductible expense, like wages. To the partner, it is ordinary income subject to self-employment tax, reported on the K-1 and taxed in the year the partnership’s year ends. Because nothing was withheld, a partner receiving guaranteed payments has to make quarterly estimated payments. The first year, when nobody has told them that, is often the year the balance due comes as a shock.
Guaranteed payments are not qualified business income, so they do not get the 20% QBI deduction. The remaining profit share does. How much of a working partner’s pay is structured as a guaranteed payment versus a profit share is a decision with tax consequences, and one to make on purpose.
↑ Back to topA general partner, and in practice almost every member of an LLC who works in the business, pays self-employment tax on his or her share of the partnership’s business income plus any guaranteed payments: 15.3% up to the Social Security wage base ($184,500 in 2026), then 2.9% Medicare above it, plus the 0.9% additional Medicare tax over $200,000 single or $250,000 joint. Rental income, interest, dividends and capital gains passed through on the K-1 are not subject to it.
The law exempts a limited partner’s share from self-employment tax, except for guaranteed payments. Whether an LLC member who works in the business can claim that exemption has been argued for twenty years. The Tax Court says no: if you function as a general partner, you are taxed as one, whatever your title. In January 2026 the Fifth Circuit disagreed for state-law limited partners in a limited partnership, and the question is now headed for more courts. For a working member of a Colorado LLC, the safe position is still that the income is subject to self-employment tax, and we prepare returns that way unless the facts clearly say otherwise.
This is also where the S corporation comparison comes in, below.
↑ Back to topBasis is your tax investment in the partnership: what you put in, plus the income you’ve been taxed on, minus the losses you’ve deducted and the money you’ve taken out. It goes up and down every year. The partnership does not track it for you; the K-1 shows a capital account, which is close but not the same thing. The partner, or the partner’s preparer, keeps the basis schedule.
Three things make it matter:
One feature with no equivalent in an S corporation: a partner’s share of the partnership’s debt counts as basis. An LLC that buys a building with an 80% mortgage gives its members basis they never paid for, which is why real estate is so often held in partnerships. The reverse is also true: when the loan is paid down or refinanced away, basis falls, and a partner can have a taxable “distribution” without receiving a dollar.
Starting with 2024 returns, a partner who receives property (not just money) from a partnership must attach a new form, Form 7217, reporting the property and its basis. A distribution of a truck, a lot, or shares of stock now has its own paperwork.
↑ Back to topA loss on your K-1 is not automatically a deduction on your 1040. It has to pass four tests, in order, and each one can stop it:
Most small-partnership losses that get disallowed fail the first or third test. A new LLC that loses $40,000 in its first year, with two members who each put in $10,000 and no debt, gives each member a $10,000 deduction now and $10,000 waiting for basis.
↑ Back to topA partner’s share of the partnership’s business income qualifies for the 20% deduction on the same terms as a sole proprietor’s profit; see our QBI page for the thresholds and the service-business rules. The partnership reports the pieces on the K-1: the qualified income, the W-2 wages it paid, and the cost of its depreciable property. Guaranteed payments are excluded. The deduction is figured on the partner’s return, not the partnership’s, so two partners with the same K-1 can get different deductions depending on the rest of their returns.
↑ Back to topA multi-member LLC can stay a partnership or elect to be taxed as an S corporation. The S corporation’s advantage is self-employment tax: owners who work in the business take a reasonable salary through payroll and the rest of the profit comes out free of Social Security and Medicare tax. Our rule of thumb, explained on the S corporation page, is that the election starts to pay once the business nets about $100,000 per working owner.
The partnership wins in other situations, and they are common:
For a service business with two working owners and good profits, the S election usually wins. For anything holding property or with an unusual deal among the owners, the partnership usually does.
↑ Back to topColorado taxes each partner’s share at the flat 4.40% on the partner’s own return; the partnership files a Colorado DR 0106 but, like the federal 1065, owes nothing itself. Nonresident partners are the complication: the partnership either withholds for them, includes them in a composite return, or collects a signed agreement that they will file. A Colorado partnership with a partner who moved to Arizona has a filing problem every year until that is set up.
Since 2022 a partnership may elect to pay Colorado’s 4.40% at the entity level, deduct it federally outside the SALT cap, and pass a credit through to the partners. With the SALT cap raised to $40,000 for most taxpayers from 2025, the election helps fewer people than it did, but for a partnership with high-income partners who are over the cap it is still worth running the numbers each year. The procedure is on our footnotes page for the Colorado PTE election.
↑ Back to topYes. A two-member LLC is a partnership and must file Form 1065 and give each of you a K-1, even for a small or break-even year. Reporting half the income on each Schedule C instead is a common mistake, and the late-filing penalty on the 1065 runs per partner per month from March 15. If you are already past the deadline, call us; the small-partnership waiver often applies.
Because the partnership earned it and it is yours, whether it sits in the partnership’s account or in your own. The income was allocated to you; the cash can follow later, tax-free, because the tax was already paid. Partnership agreements usually provide for a “tax distribution” each spring for exactly this reason. If yours doesn’t, it should.
You took out more than your basis. Your basis, your investment plus taxed income minus losses and earlier distributions, was $42,000; the $8,000 above it is gain under the rules for distributions. This is the usual result when a partnership refinances a building and distributes the cash. The gain isn’t wrong; the surprise is that nobody checked basis before the distribution.
Not as a partner. A partner cannot be an employee of the partnership; pay for services is a guaranteed payment with no withholding, and you make estimated payments instead. If the point is to have payroll and withholding, that is the S corporation election, which changes several other things at the same time. Either way, the answer is to plan the estimates, not to issue a W-2 that the IRS will treat as wrong.
For the Tax Shop desk · forms, code sections, and the things that get missed
Almost every partnership problem we untangle at the desk started with an operating agreement that didn’t say what the partners thought it said, or didn’t exist. Who gets what share of profit and loss, whether a working partner is paid before the split, what happens when a partner wants out, dies, or stops working, and who has authority to sign for the LLC are legal decisions that have tax consequences for years. We handle the tax side: the 1065, the K-1s, the basis schedules, the elections. The agreement belongs with a lawyer who knows business and tax law.
Tyler Murray, Murray & McCarthy Law
We often refer clients to Tyler Murray in Denver. He’s a former chair of the Tax Law Section of the Colorado Bar Association, holds an LL.M. in Taxation, and helps business owners form their companies and handle the legal issues that come up afterward. mmcoloradolaw.com
If you started a business with someone this year, the 1065 is due March 15 and the penalty clock starts the next day, so get the books to us early. If you have been a partner for years, the question to ask is whether anyone has a basis schedule for you; if the answer is no, that is the first thing we’ll build, because every distribution, loss, and eventual sale depends on it.
Call 303-734-1040 or stop by the office in Lone Tree. We’ve been reading the footnotes for Douglas County and the Denver area since 1969.
Figures reflect the 2026 tax year as currently published and are rounded for readability. Items marked (verify) are to be confirmed against IRS or Colorado DOR sources before the figures freeze in December. Last updated October 19, 2026.
