Partnerships should use Schedule K-1 tax forms to distinguish partnership income from owners' income. By doing this, your business will more likely avoid the $54,171 tax penalties the average business faces yearly for tax evasion. Completing and filing a Schedule K-1 form may seem difficult initially, but with the guide below, it doesn't have to be.
What is a Schedule K-1 Tax Form?
A Schedule K-1 tax form can be found on IRS Form 1065 - this is the form you will use to report the net income of your partnership for the relevant tax year. Partners in a partnership or LLC will receive schedule K-1 from the partnership.
Note: Each partner will use a Form K-1 to report their share of the business losses, credits, and deductions to the IRS.
Who has to file a Schedule K-1 tax form?
All partnerships must file Schedule K-1 tax forms for each of their partners as part of their tax returns. Additionally, partners must include a K-1 tax form with their tax return, whether they are a partner in a partnership, limited partnership, limited liability company, or LLC taxed as a partnership. You must also submit a Schedule K-1 if you are an S Corps.
Partners must file Schedule K-1 because the IRS taxes partnerships as "pass-through" entities. A company's profits and losses "pass-through" the company to all members without paying taxes. Schedule K-1 quantifies this gain or loss and, perhaps most importantly, clarifies how much of your partnership income or loss you must include on your tax returns.
Schedule K-1 Forms for Business Partnerships
Because the co-owners of a partnership, rather than the corporation itself, pay taxes on the corporation's income, the partnership must file multiple Schedule K-1 forms. In this way, each shareholder's share of the taxable profit or loss is regularly recognized for both the company and the individual owners.
In addition, each partner should receive a copy of Schedule K-1 to use on their personal tax returns. While this arrangement may seem tedious or confusing, filing and distributing Schedule K-1s is easy, and a few examples should clarify it.
Let's say you are a business partner earning $50,000 in taxable income in a given year. If you and your sole proprietorship own 50% of the business each, you should each receive a K-1 showing an income of $25,000. For four equal members, this amount is reduced to $12,500. For one partner who owns 60% and another who owns 40%, the former will receive a K-1 for $30,000 and the latter for $20,000.
Schedule K-1 Forms for LLCs
By default, your LLC (Limited Liability Company) is a partnership, but you can submit documents to the IRS to register it as a different type of federal business structure. Whether you will need to file a Schedule K-1 form for your LLC taxes depends on this structure. If your business is a C-corps or sole proprietorship, you do not need to file a Schedule K-1. Otherwise, K-1 forms are required.
If your business is a partnership, you will file a K-1 as described above. The process works a little differently for S corporations. Your corporation's annual Form 1120-S tax return must include K-1 forms for each shareholder. Each K-1 must list the shareholder's gains, credits, losses, and deductions. Each shareholder will also receive a copy of the K-1 to use with their personal tax return.
K-1 Forms for trust and estate beneficiaries
Sometimes a living trust is a partner in a partnership. If so, you need to know how K-1 forms work for funds or property.
If a trust or estate transfers its tax burden to the beneficiaries, the trust or estate must include a Schedule K-1 on the IRS 1041 tax return form and send a copy to the beneficiary. The beneficiary will then include this Form K-1 with the individual tax returns. This K-1 will likely include more cash recorded as distributions than ordinary income.
How to complete a K-1 form
To complete a K-1 form, follow these steps:
1. Indicate the fiscal year in question.
You should see the boxes for adding the start and end dates of the tax year in the upper left corner of Form K-1. Please complete them before proceeding further.
2. Add your basic identifying information.
In Part I of Form K-1, you should see spaces to add your Employer Identification Number, business name, and address. Add this information here.
3. Indicate the IRS institution where you filed your tax return.
You will need to add this information to Part I, Box C. Check your previous tax return or ask your accountant to find this information.
4. Add the partner's identifying information.
Each Form K-1 completed by your partnership is for one partner only. To ensure that you are not sending the wrong information to the wrong partner, add the appropriate member ID number (possibly a social security number), name, and address at the top of Part II.
5. Indicate the type of partner.
Use Part II, box G, to indicate whether the member is general or limited. In box H, tick national or foreign partners as appropriate. Then, in box I1, write "individual" to indicate that a partner is a person, not an entity.
6. Indicate the shareholder's profits, losses, and share capital.
If the partner in question owns 50% of your business, please indicate that percentage in all six fields of Part II, box J. The numbers in the "ending" column will only differ if the partner's ownership has changed at any time during the tax year.
7. Complete the capital liabilities and capital account fields.
Assuming your partnership uses accrual-based accounting, you must complete Part II, boxes K and L, to reflect the partner's share of the securities listed there. This part can be tricky, but an accountant can guide you based on your books.
8. List any property contributions with integrated gain or loss.
Sometimes the resources that a partner contributes to a business have built-in profits or losses. Check the appropriate entry in Part I, box M, to indicate such gains or losses.
9. Add the partner's ordinary business income
In Part III, Box 1, you must add the direct business income of the partner. If the partnership generated an income of $75,000 during the tax year and the partner owns 50% of the business, their income for box 1 would be $75,000 x 0.5 = $37,500.
10. Add additional line items for income.
Often, you will also need to add dollar amounts for the following items in Part III:
Guaranteed payments (boxes 4a, 4b and 4c)
Interest income (box 5)
Section 179 equipment deductions (box 12)
Other deductions (box 13)
Income from independent activities (box 14)
Distribution (box 19)
Your accountant can find most of these numbers easier than you, but calculating the earnings yourself is usually straightforward. It is generally the same as normal business income because the IRS imposes self-employment taxes on businesses with pass-through tax structures.
11. Complete Form K-1 and give copies to all partners.
After following the steps above, your Form K-1 is ready. Add it to your IRS Form 1065 and send a copy to each partner. Individual instructions for use are available on the second page of Form K-1.
Bottom Line
Despite the above guide, you probably still have doubts because Part III of Form K-1 has more than a dozen fields in which you can enter gains or losses. If you have any questions, ask your accountant or bookkeeper. If you don't already have one, decide if an accountant or bookkeeper is right for you, then hire one. With a financial expert on your side, your business tax compliance should be much less of a hassle.
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