Schedule K-1: What to Know About Investment Partnership Interests
What is Schedule K-1?
The U.S. tax code allows for certain businesses and trusts to pass income-tax liability onto the shareholders or partners who have a vested interest in the business. Partnerships, S corporations, trusts or estates that shift income taxes from the entity to its partners, shareholders or beneficiaries are referred to as pass-through entities. Schedule K-1 is the federal tax form prepared by these entities to report annual income, losses, credits, deductions and other distributions for each partner, shareholder or beneficiary.
If you receive a Schedule K-1, you’ll need to use the information on it to complete and file your personal income tax return.
Who files a Schedule K-1?
Generally, the partnership itself is not liable for taxes on income generated by the business. Instead, each partner is subject to those income taxes based on their ownership percentage in the business.
When a partnership files Form 1065 with the IRS, outlining its financials, it must also prepare a Schedule K-1 for each partner to reflect their share of any profits or losses or distributions from the business. Upon receiving their Schedule K-1, each partner includes the information on their personal tax return for the year.
For example, you and a partner own a business that generates $100,000 of taxable income in a year. If you own 50% of the business, you would get a K-1 outlining your $50,000 share of that income. The amount of tax you owe will be based on your overall federal income tax bracket for the year.
Similar to partnerships, S corporations may also pass the burden of income taxes to their shareholders. S corps must file Form 1120-S each year, providing a detailed picture of income, gains, losses, deductions and credits to the IRS.
An S corp also prepares a Schedule K-1 for each shareholder that reflects the shareholder’s percentage of income or loss. Once each shareholder receives their K-1, they transfer the information to file with their personal tax return for the year.
Trusts and estates
Trusts and estates use Form 1041 in their tax filing. While some trusts and estates pay income taxes directly, others will pass the income through to their beneficiaries. In cases where the income is passed through, the fiduciary managing the trust will need to prepare a Schedule K-1 for each beneficiary that received a percentage of income.
Exchange-traded funds investing in commodity futures or currencies are often set up as limited partnerships. Investors holding such ETFs may receive a Schedule K-1 reporting their share of partnership income rather than receiving it on a 1099. Unsure whether you own an ETF that’s structured as a limited partnership? You should be able to find this information in the fund prospectus, or you can check with your tax advisor. It might also save you having to amend your taxes later on.
Understanding Schedule K-1
The 2017 Tax Cuts and Jobs Act established a tax benefit for owners of pass-through businesses. Under the law (which lasts through 2025, unless it is extended by Congress), owners of businesses that qualify as pass-through entities can deduct up to 20% of their net business income from their individual income taxes. In other words, once you receive a Schedule K-1, you may be able to knock down your personal tax liability.
Say you’re an owner in a general partnership, and your Schedule K-1 states that your share of pass-through income from the business this year was $50,000. You could reduce your taxable income by up to 20%, which would bring it down to $40,000. The amount of taxes you’d owe on this income would depend on your overall income and which tax brackets apply to you, but your total income tax liability could well be reduced.
While there may be significant savings under the pass-through allowance, there are many stipulations that dictate which businesses and what sorts of income qualify. A tax advisor can help you see whether you might benefit.
There are a variety of ways that income from a partnership might be reflected on a Schedule K-1: from rental properties, royalties, interest, dividends, capital gains, to name a few. Additionally, some partnerships may have guaranteed payments that go to the general partner for managing the business operations. All of these income sources will be reported on a Schedule K-1, but the details of who owns what are likely spelled out in the partnership agreement.
Partnership agreements should cover the allocation of profits and losses, who holds decision-making authority, management duties, details on adding a new partner, what happens if a partner withdraws or passes away and other important details about how the business is structured.
If you’re involved in a partnership or are considering entering one, you may want to consult a legal advisor to make sure you have a full understanding of the partnership agreement and how it informs documents such as Schedule K-1.
Schedule K-1 requires pass-through businesses to track each partner’s basis, or stake, in the company. Basis can be increased or decreased each year depending on each partner’s profits, losses, additional contributions or withdrawals.
Say a partner contributed $20,000 in cash to the business, as well as real estate property for business operations worth $50,000. When the partner receives their Schedule K-1, it states that their share of business profits for the year was $15,000. This means that this partner’s total basis for the partnership would be $85,000.
While your K-1 will report some details about your basis, it’s important that you have a handle on those figures yourself, and a tax advisor can help determine whether you need to report a gain or a loss when filing your individual taxes.
When is Schedule K-1 due?
Schedule K-1s are due to be prepared and sent out by March 15 of each year. Unfortunately, they have a reputation for being late. And with the tax-filing deadline just a month later, there’s a real chance for headaches.
If you’re expecting a K-1 and haven’t received one on time, you might choose to file for a tax extension (though that only delays filing, not having to pay if you owe taxes). If you file your taxes and receive a K-1 afterward, you will have to amend your tax return.
If you’re worried about Schedule K-1 or have additional questions, consult with a tax advisor ahead of time to make sure you have a firm understanding of what to expect.
Steve Hansen, Vice President, Underwriting, Architects & Engineers/Contractors Professional Liability, Tokio Marine HCC – Cyber & Professional Lines Group,…