What Is A K-1?

Schedule K-1 is a tax document that is used by shareholders – of a business, financial entity, or S corporation – to report income, losses, and dividends. Whenever a trust or estate distributes income to a beneficiary, they also use the K-1 form to report the distribution. While individual taxpayers typically don’t need to file Schedule K-1s, they are widely recognizable in the business scene, with more than 40 million relevant partners or shareholders receiving the form.

Basics of Schedule K-1

Investors prefer the business structure of partnerships, LLCs, or S-corporations because of the pass-through property; meaning, shareholders only get taxed once. The U.S. federal tax code requires those business entities to issue K-1 forms to relevant parties to report their gains, losses, deductions, credits, and distributions stemming from the business’s operation. Essentially, Schedule K-1s allow regulators to gauge the participation of each shareholder in the business.?

Depending on the nature of the business, involved individuals file different forms of Schedule K-1. Particularly:

• A partnership, which distributes earnings to the partners, will use the information on the Schedule K-1 to file Form 1065.
• In the case of an S-corporation, shareholders will use the K-1 to file tax with Form 1120-S. The 1120-S form will help the IRS to determine the stake ownerships of each investor.
• Beneficiaries of trusts and estates will use Form 1041 to report income (shown on K-1) received from a passing descendant.

In addition, taxpayers should expect to receive Schedule K-1s by March 15, or sometimes by the third month after the end of the business’s fiscal year. The partner or shareholder then has until April 15 to report their individual returns.?

Implications of Schedule K-1

Before two or more people establish a partnership, they will require a partnership agreement. The agreement outlines the contributions, management and decision-making, and profit and loss distributions. The last point is important as it impacts the information on Schedule K-1s. Specifically, tax authorities will want to know how much gains or losses each shareholder incurs.?

For example, suppose a partnership specializing in real estate ventures racks up $50,000 in losses after two years of conducting the business. However, in the third year, as the housing market revives after a slump, the partnership generates $150,000 in profits. Naturally, the partners don’t have to pay any tax during the first two years, as the business doesn’t make any money. However, as the third year arrives with a profit, the partners are now owed $100,000 ($150,000 - $50,000) in taxes.?

Note that, in total, they are only subject to $100,000 in taxes instead of $150,000, the reason being any record of losses can be reported on the Schedule K-1 and carried over the subsequent years for tax deductions. As well, net losses can accumulate over consecutive years to reduce future income. Furthermore, to determine the amount of tax owed by each partner, that will be calculated based on their percent ownerships and the respective profits or losses.

Schedule K-1 and self-employment tax

In a partnership, while generally, the limited partners receive their income only when the business makes a profit, general partners might have the privilege of guaranteed payments outlined in the agreement. This is to compensate for the time and effort that general partners spend to manage the business venture, and the guaranteed payments are reported on Schedule K-1s.?

General partners, as mandated by IRS, are subject to self-employment tax, including distributive share of the income or loss, as well as the guaranteed payments. Limited partners, on the other hand, don’t have to pay self-employment tax on distributive share of income, but do pay the self-employment tax on guaranteed payments, if there are any.?

Filing Schedule K-1

Partners in a partnership will utilize the information on Schedule K-1 to complete their income tax returns. While it’s generally unnecessary to include the K-1 form (unless instructed otherwise), they still need to keep it on the records just in case. The partnership must submit a duplicate of Schedule K-1/Form 1065, the U.S. Return of Partnership Income, to the IRS.

In the shareholder case, they will refer to the details provided in Schedule K-1 (Form 1120-S) to prepare the income tax return. Similar to partners, they typically don’t need to attach the K-1 form with their returns but hold onto it for their records. The corporation must file Form 1120-S, the U.S. Income Tax Return for an S Corporation, with the IRS.

As a beneficiary of a trust or estate, the individual will also use the information on Schedule K-1 (Form 1041). Unless box 13, code B indicates backup withholding, he or she doesn’t need to submit the K-1 form with their returns, but they must retain it in the records. The trust or estate must file a copy of Schedule K-1/Form 1041 with the IRS.

Challenges of processing Schedule K-1

Processing K-1 forms can present a cumbersome and time-consuming activity for the tax and accounting firm. Though the problem can be attributed to a wide range of factors, here are some general ones:?

• K-1 form comes in different formats that may include unstructured data, free-form text, statements, footnotes, and disclosures. Practitioners have to parse through a mountain of documents with disparate information in a mostly manual process.?
• The financial information reported in the Schedule K-1 may be tailored to state, federal, and international taxes.?
• The tiered partnership structure only makes the process more complex and prone to the risk of making errors.?

Conclusion

Overall, Schedule K-1 is a tax document that allows shareholders, beneficiaries of trusts or estates, and partners to report their income, losses, and dividend received from a business or financial entity. And depending on the nature of the business, different forms of Schedule K-1 are used.