Demystifying the K-1 Tax Form: What You Need to Know

Have you ever received a K-1 form and felt you were handed a cryptic message instead of a straightforward tax document? Or perhaps you didn’t even realize you would receive a K-1 for an investment in the first place? You aren’t the only one. We break down all the details of the form and its requirements here. 

• The K-1 tax form is provided by companies to clearly outline who is responsible for paying taxes on what. 
• Income reported on a K-1 can be reported in various ways, resulting in differing taxation rates. 
• You may owe taxes on income reported on a K-1 for income you have not received yet. 

What is a K-1 tax form?

K-1 forms report the taxable amounts passed through to each party (individuals and entities) who own the entity, listing what is needed to be reported on their individual tax returns. Individuals should use the information from a K-1 on their personal income tax return. 

The United States tax code allows some entities to use “pass-through taxation” when taxing an entity (company) and its owners. Pass-through taxation is a method of taxing income in which the income earned by an entity is not taxed at the entity level but instead “passed through” to the individual owners or shareholders, who then report and pay taxes on it through their personal tax returns. This approach avoids double taxation, which occurs when income is taxed at both the entity and individual levels. 

Four main types of entities are required to file a K-1

Although many elements presented on schedule  K-1 by each entity type are similar, there are some key differences. The two most similar are K-1s from domestic partnerships (think LPs, LLPs, and multimember LLCs—entity tax form 1065) and foreign partnerships (8865). The main differences between these two are merely informational and they report income similarly. 

K-1s from Fiduciary returns (trusts and estates – form 1041) are the most unique as they report income in a different order, separately report beneficiaries’ share of depreciation and amortization, as well needing a unique section for final-year trust payments.

Lastly, K-1s from S-Corporations (1120s) are also similar to K-1s from partnerships.  However, there are some key differences to note for planning opportunities:

• S-Corporations do not have a box for guaranteed payments (box 4a – 4c on a 1065 K-1) as there is no such concept at the S-corp entity level. Without diving into too much detail, guaranteed payments are a method for partnerships to pay a de facto salary to partners (most would agree that payroll for 1065 partners is a no-no). No such limitation exists for S-Corps. They can issue W-2s and pay their shareholders salaries, which could be a planning opportunity around S-Corp entity selection. 
• S-corps do not have a box for Self-employment income, as income “passed-through” from an S-Corp K-1 is not subject to self-employment tax. This advantage could be a planning opportunity around S-corp entity selection.

Read the K-1 footnotes carefully

Not only is what is on the first page, “the face”, of the K-1 important, but many of the more complex K-1s have numerous pages of footnotes providing more details regarding sources, treatments, and reallocations of income and deductions. These footnotes could include additional information that triggers foreign reporting filing requirements, additional state tax returns to file, additional details regarding gain characterization (think QSBS and carried interest), cost basis in stock, and crypto distributions, just to name a few. 

Even simple K-1s can trigger uncertainty, but complex K-1s can present significant challenges for taxpayers due to their detailed reporting requirements and need for expert knowledge in complicated tax compliance matters. 

How is income from a K-1 taxed?

There is no one-size-fits-all approach to reporting or taxing K-1 income. However, you can generally look to the following for guidance on the tax category in which the income may be taxed.   

Categories of income listed on a K-1:

• Ordinary Business Income: Taxed at the individuals’ ordinary income tax rate.

• Interest Income: Taxed at the individuals’ ordinary income tax rate.

• Dividend Income: 

• • Qualified dividends are taxed at the lower long-term capital gains rate, while

• • Non-qualified dividends are taxed as ordinary income.

• Capital Gains: 

• • Long-term capital gains are taxed at preferential rates (0%, 15%, or 20%, depending on the taxpayer’s income level). 

• • Short-term capital gains are taxed as ordinary income.

• Rental Income: Taxed as ordinary income but may also be subject to passive activity loss rules.
• Guaranteed Payments: Taxed as ordinary income and subject to self-employment tax if the recipient is a partner in a partnership.

You may own taxes, even if you didn’t receive cash 

Depending on the type of income (ordinary income, capital gains, etc.) and deductions reported on the K-1, you may owe taxes to the IRS, even if you haven’t received any cash distributions from the entity. Distributions reported on a K-1 represent cash or property distributed to you as a partner or shareholder. They are not necessarily tied to the entity’s taxable income for the year. An entity can have taxable income and choose not to distribute it. You may receive distributions on line 19, those rarely have impact on your taxable income for that year as it’s generally cash that has been taxed on a previous year. When you receive a K-1, you must report the income, deductions, and credits on your personal tax return. 

How it breaks down

Let’s say you are a partner in a partnership that earned $200,000 in taxable income during the year. However, the partnership decides to reinvest all its earnings and doesn’t distribute any cash to the partners. Despite not receiving any distribution, you will owe taxes on your share of the $200,000 income based on your personal tax rate.

Why some take issue with K-1s

K-1s, while essential for reporting income, deductions, and credits from entities like partnerships, S corporations, estates, and trusts, can present challenges for recipients due to several factors:

1. 1. Complexity: K-1 forms can be complex, especially for individuals unfamiliar with tax laws governing partnerships, S corporations, trusts, or estates. They often require careful review and understanding to report personal tax return information accurately.
   2. Timing: K-1s are typically issued after the tax filing deadline for individuals (April 15th in the U.S.), which can delay the preparation and filing of personal tax returns. This can be problematic for taxpayers who like to file by April 15th.
   3. Multiple K-1s: Taxpayers involved in multiple partnerships, S corporations, or trusts may receive multiple K-1 forms, each with its own complexities and reporting requirements. Coordinating information from multiple K-1s can add to the overall complexity.
   4. Passive Activity Losses: Special rules apply to passive activity losses reported on K-1s, which may limit the taxpayers’ ability to deduct losses against other income.
   5. Estimated Taxes: Taxpayers receiving K-1 income may need to make estimated tax payments throughout the year to cover their tax liabilities, as entities may not withhold taxes on behalf of the owners.
   6. Paying taxes on income, not distributions: As mentioned above, you may have to pay taxes on income without receiving distributions to cover those taxes in any given year.
   7. Audit Risk: Errors or discrepancies on K-1s can increase the likelihood of IRS scrutiny or audits, potentially leading to additional taxes, penalties, or interest.

Inheriting K-1 taxes

K-1s are crucial in reporting income from estates and trusts, especially during the final year of a trust’s existence. When a trust is terminated, the final Form 1041 and accompanying K-1s ensure that all income, deductions, and credits are correctly allocated to beneficiaries, who then report these items on their personal tax returns. Properly handling these final tax matters is essential to ensure compliance with IRS regulations and maximize potential benefits for the beneficiaries. If there are capital losses or other deductible expenses, these are also reported and can be carried over to the beneficiaries’ personal returns, potentially reducing their taxable income. 

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Any tax advice herein is not intended or written to be used.