The Pass-Through Principle of Partnership Taxation

• Pages: 25-36
• Author: James R. Repetti,William H. Lyons,Charlene D. Luke

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Chapter Two

THE PASS-THROUGH PRINCIPLE OF

PARTNERSHIP TAXATION

A. Introduction

As discussed in Chapter 1, the amoun t and character of a

partnership’s income are calculated using an “entity” approach, but

the income is taxed to the partners, not to the partnership. There are

several In ternal Revenu e Code provisions that implement this

method of taxing partnership income to partners.

Section 701, the first provision in Subchapter K, starts by

stating the basic theme that partners, and not the partnership itself,

are subject to the fede ral income tax. It is important to remember,

however, that Code provisions referring to “the taxpayer” can refer

to partnerships. Section 7701(a)(14) defines “taxpayer” as “any

person subject to any internal revenue tax.” Although, in general, a

partnership cannot be subject to the federal income tax,

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it can be

subject to some other f ederal taxes, such as payroll taxes and excise

taxes.

Consistent with the entity approach, § 702(b) then says that the

character of any item of income, deduction, or credit is determined at

the partnership level. Accordingly, if a partnership recognizes a

$10,000 gain from the sale of property, the question whether that

gain is capital gain, ordinary income, or § 1231 gain is answered at

the partnership level. If a partnership is a dealer in property, gain

from such property will be taxable as ordinary income to the partners

even though the ind ividual partners may not be dealers in such

property.

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Section 703(a) then provides guidance about how the

partnership should calcul ate the taxab le income that will flow out

and be taxable to partners and how the partnership should report

such income to the partners. It requires that the partnership

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As discussed in § H, after the audit of a certain partnerships, the IRS can

require the partnership to pay a tax on items that the partnership incorrectly reported

to its partners.

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As discussed in Chapters 11 and 12, special provisions prevent partners from

avoiding this ordinary-income taint by having the partnership distribute its ordinary-

income assets to them and then classifying such assets as capital assets in their hands.

See Chapter 11 § A.3, which discusses § 735, and Chapter 12, which discusses § 751(b).

Consistent with the theme of not avoiding ordinary income, special look-through rules

also require a partner who sells her interest in a partnership that holds ordinary

income asse ts to recognize ordinary income attributable to her share of the

partnership’s assets. See Chapter 10 § A.2, which discusses § 751(a).