For anyone with an ownership interest in a partnership or S-corp, understanding the difference between the income and distribution amounts reported on Schedule K-1 is critical.
Both terms refer to the money an investor receives from their investment. But they each have unique implications when it comes to taxes and shareholder equity.
Partnerships and S-corps use Schedule K-1 to report the amount of partnership or S-corporation earnings passed through to its investors. Distributions, on the other hand, are amounts an owner withdraws from the partnership or S corporation.
In this article, you’ll get an in-depth explanation of income and distribution amounts reported on a K-1, their differences, and their tax implications.
Schedule K-1 basics
The Schedule K-1 is a tax document that partnerships and S-corporations must file. It’s used to report the share of the entity’s income, deductions, credits, and other items allocated to each partner or shareholder.
S-corps and partnerships are referred to as pass-through entities. That means they don’t pay income taxes at the company level. Instead, their income, deductions, and credits flow through to partners or shareholders. Those individuals then report the information on their personal tax returns. The Schedule K-1 serves as a record of each partner or shareholder’s share of these tax items.
There are two primary types of Schedule K-1 forms, one for partnerships (Form 1065) and another for S-corporations (Form 1120S). While the forms are similar in nature, they’re used for different types of pass-through entities. Partnerships use Form 1065. S-corporations use Form 1120S.
The form used by limited liability companies (LLCs) depends on whether they have elected to be taxed as a partnership (Form 1065), or an S-corporation (Form 1120S).
The responsibility for filing a Schedule K-1 form lies with the partnership or S-corporation itself.
The company must prepare a separate Schedule K-1 for each partner or shareholder and provide them with a copy. This allows individual investors to accurately report their share of the entity’s income and deductions on their personal tax returns.
The partnership or S-corporation also files a copy of each owner or investor’s Schedule K-1 with the IRS for informational purposes.
What partnership income is reported on Schedule K-1?
Schedule K-1 forms report a wide range of information, including the partner or shareholder’s share of the entity’s income, credits, and deductions for the tax year. Some of the most common items reported on a Schedule K-1 are:
- Ordinary business income (or loss)
- Rental real estate income (or loss)
- Interest, dividends, and royalties
- Capital gains (or losses) from the sale, or exchange of, capital assets like stocks, bonds, or real estate
- Guaranteed payments made to partners (similar to an employee salary in many ways, these are payments made to a partner for services provided, or the use of capital, regardless of the partnership’s income)
- Credits, deductions, and other tax items
What partnership distributions are reported on Schedule K-1?
Distributions refer to owner withdrawals and payments made by partnerships or S-corporations to their shareholders or partners that exceed their share of company profits during the period. Since the partner is essentially taking money out of the company, distributions are treated as a return of the partner’s initial investment.
Because a distribution results in a reduction in the partner’s capital account, it reduces the partner’s ownership percentage in the company.
Like with partnership income, the amount of distributions made during the period is also reported on Schedule K-1, specifically in box 19. It will be classified as either a Code A, B, or C distribution, depending on whether you’ve received cash and marketable securities, or other forms of property.
Liquidating Distributions: These are payments made to shareholders or partners when the company is closing down, liquidating its assets, or undergoing a significant change in its ownership structure.
Liquidating distributions are generally considered a return of capital and aren’t taxed as income. However, they may trigger capital gains or losses for the partner or shareholder.
If a partnership sells all of its assets and distributes the proceeds to its partners, those proceeds are considered liquidating distributions and may result in capital gains.
Non-Taxable Distributions: These are payments made to partners or shareholders that don’t count as taxable income. Examples include a return of capital, stock dividends, and stock splits. Non-taxable distributions reduce the partner’s or shareholder’s basis in the company, which reduces their ownership interest.
This action can impact the tax treatment of future transactions, like the sale of the ownership interest or subsequent distributions.
A partner’s distributions reported on their Schedule K-1 are categorized by the partnership as Code A, B, or C—this helps partners and shareholders determine the tax treatment of these distributions on their individual tax returns. By understanding the different types of distributions and their tax implications, partners and shareholders can better manage their investments in pass-through entities and avoid potential tax pitfalls.
K-1 income vs. distribution: key differences
When dealing with investments in partnerships or S-corporations, it’s crucial to understand the key differences between K-1 income and distributions.
These differences can impact the amount of tax owed by a partner or owner, so let’s discuss some key distinctions between K-1 income and distributions.
K-1 Ordinary Business Income:
The amount of ordinary business income (or loss) reported on Schedule K-1 represents the owner’s share of the company’s taxable income. This income is earned by the entity but not necessarily distributed to its owners.
Tax Implications: K-1 ordinary business income is typically reported on the individual owner’s personal tax return and taxed at their marginal tax rate. It may be subject to self-employment tax for partners actively engaged in the business.
Deductions: Investors can potentially deduct certain expenses related to their share of the partnership or S-corporation’s income, such as unreimbursed partnership expenses and investment interest expenses.
Impact on investor: The amount of ordinary business income reported on an owner’s K-1 doesn’t impact their equity or ownership percentage. It only represents their share of the entity’s earnings for that period. Since the company itself doesn’t pay tax, the income is reported on each partner’s return.
Distributions:
Distributions occur when a partnership or S-corporation distributes cash or securities to its owners that aren’t considered ordinary business income. Distributions typically cause the company’s assets to decrease and the owner’s assets to increase.
Tax Implications: The tax treatment of distributions depends on the nature of the distribution. Some may be taxed at the partner’s or shareholder’s ordinary income tax rate, while others may trigger capital gains or losses.
Deductions: There are no specific deductions available for distributions; however, investors may be able to offset capital gains with capital losses from other investments.
Impact on investor: This distribution reduces the partners’ equity in the company, as it represents a return of capital. Distributions in excess of the partner’s equity in the company may be taxed as ordinary income.
When to expect K-1 income vs. distributions
The timing of K-1 income and distributions is essential for investors in partnerships and S-corporations to understand, as it’ll impact their tax planning and cash flow management.
The allocation of K-1 income is generally determined by the partnership or S-corporation’s fiscal year, which often coincides with the calendar year. The entity calculates its income, deductions, and credits for the year. It then allocates each partner or shareholder’s share accordingly. Investors should expect to receive their Schedule K-1 forms by early spring, as partnerships and S-corporations are typically required to send them out by March 15th.
The timing of distributions is determined by the company’s board of directors or the partnership agreement. Distributions can be made periodically throughout the year, such as quarterly or annually, or they may be issued on an ad hoc basis. Investors should stay informed about their investment’s distribution schedule to effectively manage their cash flow and anticipate tax liabilities.
Keeping track of K-1 income and distribution payment dates is important because:
- Accurate record-keeping can help investors avoid potential tax penalties, facilitate accurate tax planning, and allow them to make informed decisions regarding their investment strategies.
- By staying informed about the timing of K-1 income and distributions, investors can better manage their investments in pass-through entities and optimize their financial outcomes.
How to report K-1 income vs. distributions
Reporting K-1 income and distributions accurately on an individual tax return is essential to make sure you’re compliant with tax laws and avoid potential penalties.
To report K-1 income, first, you’ll need to receive your Schedule K-1 form from the partnership or S-corporation. This form will give you all of the necessary details about your share of the entity’s income, deductions, and credits.
You’ll report this information on your individual tax return, typically using Form 1040. Partnerships will report their share of income on Schedule E (Supplemental Income and Loss) of Form 1040. S-corporation shareholders will report their share of income on Schedule E, Part II.
Distributions are reported in Box 19 of Schedule K-1. Liquidating and non-taxable distributions may have different tax implications, like triggering capital gains or losses. Make sure to keep track of your distribution records and consult a tax professional to ensure accurate reporting of these amounts.
Common mistakes to avoid:
- Not reporting K-1 income or distributions: Failing to report this information can result in penalties and interest from the IRS.
- Reporting K-1 income or distributions in the wrong section of your tax return: Make sure to report each item in the appropriate section of your tax return to avoid discrepancies. It’s important to sit down with a tax professional to discuss many of the aspects we’re discussing, as the answers aren’t one-size-fits-all.
- Incorrectly calculating your basis in the partnership or S-corporation: Keeping an accurate record of your basis will help you properly report gains, losses, and other tax consequences related to your investment.
The tax code specifies different rules for whether amounts reported on a Schedule K-1 are considered active or passive income, depending on the investor’s level of involvement in the company.
Understanding partnership agreements
Partnership agreements play a significant role in determining how K-1 income and distributions are allocated among partners, making it crucial for investors to understand their contents.
These agreements outline the rights, responsibilities, and financial arrangements between partners.
Key terms to look out for in partnership agreements
Profit and loss allocation: This term refers to the method and ratio by which the partnership’s profits and losses are allocated among partners. It directly impacts each partner’s share of K-1 income.
Capital contributions: This term refers to the initial and any subsequent investments made by partners into the partnership. Capital contributions can affect the partner’s equity and tax basis in the partnership.
Guaranteed payments: This term outlines the conditions and procedures for payments made to owners for services they provide to the company. Guaranteed payments are typically taxed as ordinary income, and are similar to an employee salary (since they’re received in exchange for managing, or providing some other service, to the company).
Reviewing partnership agreements is essential for several reasons:
Clarity: Understanding the agreement ensures you are aware of your rights, responsibilities, and financial arrangements within the partnership.
Tax planning: By being aware of the allocation of profits, losses, and distributions, you can better plan for your tax liabilities.
Investment strategy: A clear understanding of the partnership agreement can help you make informed decisions regarding your investment and manage potential risks.
K-1 income and distributions in limited partnerships vs. S corporations
Both limited partnerships and S-corporations use Schedule K-1 to report income and distributions to their investors. However, there are some key differences in how these entities treat K-1 income and distributions, as well as their tax implications.
In limited partnerships, K-1 income is allocated to general and limited partners based on the partnership agreement. The allocation may be based on ownership percentages, capital contributions, or other agreed-upon formulas outlined in the partnership agreement.
In S-corporations, K-1 income is allocated to shareholders based on their percentage ownership of the company. This is determined by the number of shares that they own.
Conclusion
K-1 income and distributions both have tax implications for any investor with an ownership interest in a partnership or S-corporation. You need to understand the nuances of these situations and whether they apply to you. That way, you can file your tax return accurately and avoid penalties from the IRS.