Partnership Tax Planning: Allocations, Distributions & Strategies

Key Takeaways

• Partnership tax planning requires coordinating multiple partners’ individual tax situations
• The choice between guaranteed payments and distributions has significant tax implications
• Special allocations can shift income and deductions to partners who benefit most
• Basis tracking is critical for distribution planning and loss deductions
• PTE elections offer SALT cap workarounds for partnerships in participating states
• Bobby’s Big Four background includes hundreds of complex partnership returns

Partnership tax planning is fundamentally different from S-Corp or sole proprietor planning. You’re not just optimizing one taxpayer’s situation. You’re coordinating multiple partners with different income levels, tax brackets, and financial goals.

That complexity creates opportunity. Partnerships offer flexibility that other entity types don’t: special allocations, guaranteed payment structuring, and basis planning. When done right, partnership tax planning can save partners tens of thousands of dollars collectively.

At SDO CPA, partnerships are a core specialty. Bobby’s background at EY and KPMG included hundreds of partnership returns, from simple two-person LLCs to multi-tiered investment structures. This guide covers the strategies that make the biggest difference for most partnership owners.

Why Partnership Tax Planning Is Different

Partnerships face unique planning challenges and opportunities.

Multiple Taxpayers: Each partner is a separate taxpayer with their own:

• Income level and tax bracket
• State of residence
• Other income sources
• Deduction limitations

No Entity-Level Tax: Like S-Corps, partnerships are pass-through entities. Income, deductions, and credits flow through to partners via Schedule K-1.

Allocation Flexibility: Unlike S-Corps (which must allocate pro-rata by ownership), partnerships can use special allocations to shift items to partners who benefit most. This is one of the most powerful partnership planning tools.

Basis Complexity: Partner basis determines:

• Whether distributions are taxable
• Whether losses are deductible
• Gain or loss on sale of partnership interest

Tracking basis correctly is essential. Get it wrong, and you’ll face surprise tax bills or missed deductions.

For foundational partnership concepts, read our complete guide to partnership taxation.

Guaranteed Payments vs. Distributions

One of the most important partnership decisions: How should working partners be compensated?

What Are Guaranteed Payments?

Guaranteed payments are payments to partners for services or capital use, made without regard to partnership income. Think of them as the partnership equivalent of a salary.

Tax treatment:

• Reported separately on Schedule K-1 (Box 4)
• Subject to self-employment tax (15.3% up to the $176,100 Social Security wage base for 2026)
• Deductible by the partnership (reduces partnership income)
• Reduces QBI for all partners (guaranteed payments reduce qualified business income)

See our detailed guide on guaranteed payments to partners.

What Are Partner Distributions?

Distributions are withdrawals of a partner’s share of profits. They’re not compensation for services; they’re a return of income that’s already been allocated to the partner.

Tax treatment:

• Generally not subject to self-employment tax
• Don’t affect partnership income (not deductible)
• Tax-free up to partner’s basis
• Don’t reduce QBI (distributions aren’t separately stated)

For distribution mechanics, see our guide on partnership distributions.

When to Use Each

The choice between guaranteed payments and distributions affects self-employment tax and QBI deductions.

Use Guaranteed Payments When:

• Partner provides services worth a specific amount regardless of profits
• You want to ensure consistent compensation even in loss years
• The partner needs SE tax credits for Social Security

Use Distributions When:

• Partners want to minimize self-employment tax
• Preserving QBI for all partners is priority
• Partners are compensated primarily through profit sharing, not services

Dollar Example: $150,000 Total Compensation

The distribution approach saves $18,500 in SE tax for this partner. But there are limits: If a partner provides substantial services, the IRS may recharacterize distributions as guaranteed payments.

The QBI Impact

Guaranteed payments reduce the partnership’s qualified business income, which affects all partners’ QBI deductions.

Example: Partnership has $500,000 QBI before guaranteed payments. Partner A receives $100,000 guaranteed payment.

• QBI after guaranteed payment: $400,000
• Partner A’s QBI: Share of $400,000 (not the $100,000 guaranteed payment)
• Result: Partner A gets SE tax on $100,000 AND lower QBI deduction

This is why many partnerships are shifting away from guaranteed payments when legally defensible.

For more on how QBI works, see our QBI deduction guide.

Special Allocation Strategies

Special allocations are one of the most powerful partnership planning tools. They allow partnerships to allocate income, deductions, and credits differently than ownership percentages.

What Are Special Allocations?

Instead of splitting everything 50/50 between two equal partners, special allocations let you:

• Allocate depreciation to the partner who needs deductions
• Shift capital gains to partners in lower brackets
• Direct tax credits to partners who can use them

S-Corps can’t do this. S-Corp allocations must be pro-rata by ownership. Partnerships have flexibility.

Common Special Allocation Uses

Depreciation Allocation: Partner A is in a high tax bracket and needs deductions. Partner B has lower income and can’t use additional deductions. Allocate depreciation to Partner A.

Capital Gain Allocation: Partner A is in the 0% capital gains bracket. Partner B pays 20% on capital gains. Allocate more capital gains to Partner A.

Tax Credit Allocation: Partner A has tax liability to offset. Partner B doesn’t. Direct tax credits to Partner A.

Loss Allocation: Partner A has basis to absorb losses. Partner B doesn’t. Allocate losses to Partner A (who can deduct them).

Substantial Economic Effect Rules

Special allocations aren’t free-form. They must have “substantial economic effect” under IRS regulations.

Economic Effect Test: The allocation must actually affect the partner’s economic position. If Partner A is allocated depreciation, Partner A’s capital account must reflect that allocation.

Substantiality Requirement: The allocation must have a reasonable possibility of substantially affecting the dollar amounts received by partners independent of tax consequences. Pure tax-shifting without economic substance doesn’t work.

Safe Harbor: Partnerships can satisfy these requirements through:

• Maintaining capital accounts
• Liquidating according to positive capital accounts
• Deficit restoration obligations or qualified income offset

Bottom line: Special allocations work, but they need proper documentation in the partnership agreement and must reflect real economic arrangements.

Section 704(c) Allocations

When partners contribute property with built-in gain or loss, Section 704(c) prevents tax shifting.

Example: Partner A contributes property worth $100,000 with a $40,000 basis (built-in gain of $60,000). If the partnership sells the property, Section 704(c) requires the $60,000 built-in gain to be allocated to Partner A, not shared among partners.

Methods:

• Traditional method: Allocates built-in gain to contributing partner, but may create “ceiling rule” issues
• Remedial method: Creates offsetting allocations to prevent inequity
• Traditional method with curative allocations: Hybrid approach

Proper 704(c) compliance requires careful tracking and partnership agreement provisions.

Partner Basis Planning

Basis is everything in partnership taxation. It determines whether losses are deductible, whether distributions are taxable, and what gain or loss you’ll recognize when you sell.

Why Basis Matters

Loss Deductions: You can only deduct partnership losses to the extent of your basis. If you have $50,000 of allocated losses but only $30,000 of basis, $20,000 is suspended until you have more basis.

Distribution Taxation: Distributions are generally tax-free up to your basis. Excess distributions are capital gain. If you take a $100,000 distribution with only $60,000 basis, you recognize $40,000 capital gain.

Sale of Interest: Your gain or loss on selling your partnership interest is sale price minus basis. Accurate basis tracking is essential for proper reporting.

Read our partner basis calculation guide for detailed mechanics.

Increasing Partner Basis

Several items increase your partnership basis:

Cash contributions: Direct investment in the partnership

Property contributions: Basis of contributed property (with adjustments)

Share of partnership liabilities:

• Recourse debt: Allocated based on economic risk of loss
• Nonrecourse debt: Allocated based on profit-sharing ratio (generally)
• Liability allocation is one of the most complex partnership tax areas

Allocated income: Your share of partnership income increases basis

Basis Planning for Distributions

Before taking large distributions, verify your basis.

Planning steps:

1. Calculate current outside basis (contributions + income – distributions – losses)
2. Factor in liability share changes
3. Compare to planned distribution amount
4. If distribution exceeds basis, recognize capital gain

Year-end verification: Before December 31st, verify each partner’s basis. This prevents surprise taxable distributions and ensures losses can be deducted.

At-Risk and Passive Loss Rules

Even with sufficient basis, deductions may be limited:

At-Risk Rules: Losses are deductible only to the extent you’re “at risk” in the activity. Generally, this means your basis minus amounts protected from loss (like nonrecourse debt on property you’re not personally liable for).

Passive Activity Rules: Limited partners are generally treated as passive. Losses from passive activities can only offset passive income, not wages or active business income. Suspended losses carry forward.

Material Participation: General partners who materially participate (500+ hours, substantially all participation, etc.) may be non-passive. This allows losses to offset other income.

PTE Election Strategies

Pass-through entity (PTE) elections allow partnerships to pay state income tax at the entity level, providing a workaround for the federal SALT cap.

What Is the PTE Election?

Under OBBBA, the SALT cap increased to $40,000 (from $10,000), but many partnership owners still hit the limit.

The PTE election works like this:

1. Partnership pays state income tax at the entity level
2. Partners receive a state credit for their share of tax paid
3. Partnership’s state tax is fully deductible at the federal level (no SALT cap)
4. Partners effectively bypass the SALT limitation

States Offering PTE Elections

Over 30 states now offer PTE elections, including:

• California — Optional election, 9.3% rate
• New York — Optional election, graduated rates
• Georgia — Optional election, 5.49% rate
• Texas — No state income tax, but relevant for multi-state partnerships
• Florida — No state income tax

Each state has different rules for:

• Election timing and method
• Rate applied
• Credit mechanics
• Estimated payment requirements

See our guide on multi-state partnership filing for state-specific details.

When PTE Election Makes Sense

Analyze the numbers:

• Partners’ state income tax that would exceed SALT cap
• Partnership’s state taxable income
• Administrative cost of making and maintaining the election

Example: Partnership with $1,000,000 Texas taxable income, partners in California.

• Without PTE: Partners pay CA tax personally, limited by SALT cap
• With PTE: Partnership pays CA tax, fully deductible federally
• Savings: Potentially $30,000+ depending on partner brackets

PTE Election Timing and Mechanics

Timing varies by state:

• Some require election before year-end
• Some allow election with return filing
• Many require estimated payments

Credit mechanics: Partners claim credit on their individual state returns for their share of PTE tax paid. The mechanics differ by state.

Multi-state considerations: Partners in different states create complexity. The partnership may need to make elections in multiple states, and credit claiming varies.

QBI Deduction Planning for Partnerships

The QBI deduction flows through to partners based on their share of partnership QBI, W-2 wages, and qualified property.

How QBI Works for Partners

Each partner calculates their own QBI deduction based on:

• Their share of partnership QBI (after guaranteed payments)
• Their share of W-2 wages (for wage limitation)
• Their share of qualified property (for property limitation)
• Their individual taxable income (for threshold and limitation)

2026 Thresholds (Partner Level):

• Full deduction: Below $203,000 single / $406,000 MFJ
• Phase-out range: $203,000-$272,300 single / $406,000-$544,600 MFJ
• Full limitations: Above phase-out

The QBI deduction is now permanent under OBBBA.

W-2 Wage Limitation at Partnership Level

If partners are above the QBI threshold, their deduction may be limited by W-2 wages.

Planning implication: Wages paid by the partnership are allocated to partners. Ensure wage allocations follow income allocations for partners who need the limitation support.

Example: Partnership has $200,000 W-2 wages and two partners:

• Partner A (50% owner, above threshold): Allocated $100,000 wages
• Partner B (50% owner, below threshold): Allocated $100,000 wages

Partner A’s QBI deduction is limited to the greater of 50% of their $100,000 wage allocation ($50,000) or 25% wages + 2.5% property.

SSTB Impact on Partners

If the partnership is a Specified Service Trade or Business (health, law, accounting, consulting, etc.), SSTB rules apply to all partners.

Planning options:

• Manage partner income to stay below threshold
• Aggregate SSTB partnership with non-SSTB businesses (if ownership and management requirements met)
• Consider splitting SSTB and non-SSTB activities

Multi-Partner Planning Coordination

Effective partnership planning considers all partners’ situations.

Different Partner Tax Situations

Partners often have different:

• Income levels: High-income partner benefits from different strategies than lower-income partner
• Activity levels: Active vs. passive partners have different loss treatment
• State residence: Partners in different states face different tax rules

Planning approach:

• Model scenarios that optimize total partner savings
• Use special allocations to shift benefits to partners who can use them
• Consider PTE elections based on partners’ state situations

New Partner Admissions

Adding partners creates planning opportunities and compliance requirements.

Section 704(c) considerations: New partners shouldn’t share in built-in gains or losses from assets held before their admission. Proper 704(c) allocations prevent this.

Section 754 election: When a partner pays a premium for their interest, a Section 754 election allows basis step-up for the new partner’s share of assets. See our Section 754 election guide.

Capital contributions: Structure contributions to optimize basis and allocation outcomes.

Partner Exits and Buyouts

Partner departures require careful planning.

Sale of partnership interest:

• Gain/loss based on amount realized minus basis
• Ordinary income component for unrealized receivables and inventory (Section 751)
• State tax sourcing rules apply

Liquidating distributions:

• Generally tax-free up to basis
• Property distributions reduce basis by property’s inside basis

Section 754 benefits: If the partnership has a 754 election, remaining partners may benefit from basis adjustment when a partner leaves.

See our partnership liquidation tax guide for exit mechanics.

Year-End Partnership Planning Checklist

October (8-10 Weeks Out):

•  Review projected allocations for each partner
•  Verify basis calculations for each partner
•  Evaluate guaranteed payment vs. distribution mix
•  Analyze PTE election opportunities by state
•  Schedule partner planning discussion

November (4-6 Weeks Out):

•  Finalize special allocation decisions with partners
•  Make equipment purchase decisions (depreciation allocations)
•  Plan partner capital contributions (basis building)
•  Verify 754 election status if relevant

December (Final Month):

•  Execute final distribution timing decisions
•  Decide between cash and property distributions
•  Review liability allocation impact on basis
•  Prepare K-1 projections for partner tax planning

See our year-end tax planning checklist for more details.

Common Partnership Tax Planning Mistakes

Mistake 1: Ignoring Basis Before Distributions

Taking distributions without verifying basis leads to unexpected taxable gains.

Prevention: Calculate partner basis before every significant distribution.

Mistake 2: Wrong Guaranteed Payment vs. Distribution Choice

Using guaranteed payments when distributions work saves significant SE tax. Using distributions when guaranteed payments are required invites IRS recharacterization.

Prevention: Analyze each partner’s situation and document the rationale.

Mistake 3: Not Making Section 754 Election When Beneficial

Without a 754 election, new partners or buyer partners may pay tax on gains that accrued before their involvement.

Prevention: Evaluate 754 election with each ownership change.

Mistake 4: Improper Special Allocations

Special allocations without substantial economic effect get reallocated by the IRS.

Prevention: Ensure partnership agreement supports allocations and capital accounts reflect economic reality.

Mistake 5: Multi-State Filing Gaps

Partnerships with partners in multiple states often miss filing requirements.

Prevention: Map partner residences and partnership activity to identify all filing obligations.

Real-World Partnership Planning Example

Case Study: Real Estate Investment Partnership

Profile:

• 3-partner real estate investment partnership
• $600,000 annual net income from rental properties
• Partners with different tax situations

Partner A: High-income physician, 37% bracket, needs deductions Partner B: Business owner, moderate income, wants cash flow Partner C: Retired, 15% bracket, passive investor

Planning Approach:

1. Special allocate depreciation to Partner A — $120,000 depreciation shifted to highest-bracket partner. Tax value: $44,400 vs. $18,000 if allocated to Partner C.
2. Structure Partner B’s compensation as distributions — Avoid guaranteed payments, eliminate $15,000+ in SE tax.
3. Allocate capital gains to Partner C — Lower bracket means 15% vs. 23.8% tax on gains. On $50,000 gain, saves $4,400.
4. Make PTE election — Partners A and B are in high-tax states and exceed SALT cap. PTE election saves approximately $12,000 combined.

Results:

• Partner A: Maximum deductions, tax bracket efficiency
• Partner B: SE tax savings, cash flow preserved
• Partner C: Lower capital gains rate applied
• Combined annual savings: $47,000 across all partners

Frequently Asked Questions

What’s the difference between guaranteed payments and distributions?

Guaranteed payments are like salary and are subject to self-employment tax. Distributions are return of profits and generally avoid SE tax. Guaranteed payments also reduce partnership QBI, affecting all partners’ QBI deductions.

Can partnerships allocate income unevenly among partners?

Yes, through special allocations. Unlike S-Corps (which must allocate pro-rata), partnerships can allocate income, deductions, and credits disproportionately if the allocations have “substantial economic effect” under IRS rules.

What is partner basis and why does it matter?

Partner basis is your tax investment in the partnership. It limits how much loss you can deduct, determines whether distributions are taxable, and calculates gain or loss when you sell your interest. Accurate basis tracking is essential.

Should our partnership make a PTE election?

If your partnership operates in a state with a PTE election and partners are affected by the SALT cap ($40,000 under OBBBA), it’s often beneficial. The election allows the partnership to pay state tax and pass through a credit, effectively bypassing the SALT limitation.

How does QBI work for partnership income?

Each partner calculates their own QBI deduction based on their share of partnership QBI, W-2 wages, and property. Partners above the income threshold ($203,000 single / $406,000 MFJ for 2026) face wage and property limitations.

When should we involve a CPA in partnership planning?

If your partnership has multiple partners with different tax situations, uses special allocations, operates in multiple states, or generates significant income, professional planning typically saves multiples of the fee. Complex partnerships benefit most from proactive planning.

Get Partnership Planning Help

Partnership tax planning requires understanding each partner’s situation and coordinating strategies that optimize the group outcome.

Bobby’s background at EY and KPMG included hundreds of partnership returns, from straightforward LLCs to complex investment structures. At SDO CPA, partnerships are a core practice area.

What a Partnership Planning Engagement Includes:

1. Partner situation analysis — Income levels, brackets, state residence, other activities
2. Guaranteed payment vs. distribution evaluation — Optimal compensation structure
3. Special allocation opportunities — Depreciation, gains, losses, credits
4. Basis verification — Each partner’s current position
5. PTE election analysis — State-by-state cost-benefit
6. Year-end action plan — Specific steps for each partner

Ready to optimize your partnership? Schedule your partnership planning consultation with SDO CPA.