Partnerships or LLCs taxed as partnerships, don’t pay federal income tax. Instead we say they “flow through,” the income to their owners. So what do we mean, when we use the phrase, “Partnership Taxable Income?” There is a statutory definition to this phrase, but that definition is generally not what we are talking about. I would propose that most business owners and their accountants are referring to the ordinary income and separately stated items as their “Partnership taxable income.” These amounts are reported on the partnership tax return and reported to the owners on Schedule K-1s to use in their own income tax returns.
What is a separately stated item? My definition, appealing to intuition, is any item where the character is a matter of consequence at the partner level. These are items that are disclosed on separate forms in a person’s 1040 tax return or are given different treatments in terms of deduction and tax rates. Examples include but are not limited to, rental income, qualified dividends, capital gains and charitable deductions. The exact listing is found in the Treasury Regulations and can be seen on the Form 1065 Schedule K-1s.
Any item that is not separately stated is part of ordinary income. That ordinary income generally is the gross income from sales minus the deductions for business operating expenses. I say that, in attempt to describe what falls into the category of ordinary income. However it’s important to identify all the separately stated items, without the prejudice of feeling like something should or shouldn’t be “normal” business income. If it’s on the separately stated list, it is separately stated not ordinary income.
The amount of ordinary income and separately stated items allocated to each partner should be based on the operating agreement. This is most commonly done by expressing the percentage of profits or losses each partner is to be allocated. However the tax rules contemplate that it could be done on an item by item basis. In any case, if an LLC or partnership doesn’t have an explicit agreement for profit/loss allocations, then you are left to the operation of state laws, which will have some default allocation method for economic earnings that should also be followed for these “Partnership taxable income” components on tax returns. Each owner will receive a schedule K-1 providing their allocations for reporting on their tax returns.