Question

Describe how a partnership reports its income for tax purposes. Who makes most elections related to partnership income and deductions? Compare the treatment of the business interest expense limitation versus the qualified business income deduction. What theories underly this treatment

Answer 1

A partnership firm files the annual information return to report the income, deduction, gains and losses on Form 1065. It does not pay any taxes as it is a pass through entity and it also file schedule K to report the share of income and expenses of each partner.

The partners make all the elections related to partnership income and deduction at the partnership level.

The business interest expense limitation says that the interest expense is limited to 30% of adjusted taxable income, where adjusted taxable income is taxable income without taking into account:

1. Non business income

2. Net operating loss deduction

3. Qualified business income deduction

4. Business interest income and expenses

5. Depreciation, amortization and depletion

The qualified business income deduction is upto 20% of qualified business income subject to limitation of W-2 wages paid by the qualified trade or business.

Business interest expense limitation is based on entity theory, treating partnership as a separate distinct entity can carryforward the disallowed portion of interest expenses till it is fully absorbed.

Qualified business income deduction is based on aggregate (conduit) theory, where the income flow through to the partners, and they get a deduction of 20% of qualified business income subject to limitations.