At the start of the year, business owners are issued Schedule K-1 income earned from a partnership or S Corporation. In this guide, we will navigate you through how to figure out your K-1 basis for tax reporting.
In this article:
- What is a Schedule K-1?
- K-1 issuance deadline
- Who has to file K-1 income?
- K-1 basis reporting
- How to calculate partnership K-1 tax basis
- How to calculate S Corp K-1 tax basis
What Is A Schedule K-1?
Think of a Schedule K-1 as a W-2 or 1099. It reports annual income earned from a business. More specifically, a Schedule K-1 reports an owner’s share of profit/loss of certain pass-through business entities. Pass-through entities push business tax liability to the owners, to report on their individual tax returns.
Who Files A Schedule K-1?
Whether you file K-1 income totally depends on your business structure. Members of these pass-through entities will be issued a Schedule K-1:
- Partnerships
- LLC with a partnership election
- LLC with an S Corporation election
Partnerships report taxes using Schedule K-1 Form 1065, while incorporated entities with an S election file a Schedule K-1 Form 1120-S.
Note: Beneficiaries who share income from a trust or estate must report using a Schedule K-1 Form 1041.
K-1 Issuance Deadline
K-1’s are issued to all owners by March 15th each year. Companies will divide income and losses to each partner based on several factors. Essentially the K-1 reports the owner’s share of the company from the original agreement and any further amendments to said agreement.
Companies make sure that the cumulative K-1’s issued equal total earnings for the business. When K-1 basis reporting is incorrect, a partner can dispute the error and request a recalculation. If there is a reporting error on one, then it is likely they are all incorrect and will need to be rectified. Year-round basis reporting and tracking make issuing K-1’s seamless and help a business avoid penalties.
What Is Reported On A Schedule K-1?
A Schedule K-1 will show your percentage of profits, gains, losses, credits, and deductions from a business. As an owner, you are responsible for filing these items on your personal tax return. Some of the most common figures you will see on your K-1:
- Dividends and distributions from the company
- Guaranteed payments per the initial agreement
- Stock gains or losses
- Business capital account assessment
- Credits and deductions
K-1 Income vs Distributions
Pass-through entities avoid double taxation by passing all income to the owners. K-1 income shows your share of that income out of how much the business entity made. On the other hand, distributions are money you receive from the business during the year. Distributions can come in two forms:
- Dividend Distribution: your share of taxable profits
- Non-Dividend Distribution: when you take a non-taxable draw out from your share of the business.
When you receive a non-dividend distribution it is a non-taxable event. However, when you file your personal taxes the distribution is added to net income. Your net income is your total taxable income for the year—different from the K-1 income showing only what you received from a partnership or S-Corp.
K-1 Basis Reporting
When you are the owner of a partnership or S Corp you agree to share the responsibilities of the business. That means no matter what your tax return needs to match what is reported on your Schedule K-1. Before filing income taxes, it is the responsibility of all owners to calculate their tax basis in the company and perform a K-1 reconciliation, ensuring what has been reported is accurate. To file K-1 taxes correctly and avoid IRS penalties, here is what you should know:
What Is Tax Basis?
Tax basis is when an owner is within their rights to accept income based on their contribution to the company. They can only receive a distribution equal to their percentage of the company. If an owner does not have basis, they are depleting their basis and getting more than what they put in. Tax basis also goes by these names, they are used interchangeably, although they each reference something different:
Quick Definitions
Cost Basis: this is the initial investment a person puts into the company i.e. money or property.
Adjusted Basis: how an owner’s initial cost basis has changed because of contributions and distributions.
Ownership Basis: Same as adjusted basis.
Stock Basis: this is the initial stock an owner has in the company, referring to capital only.
Throughout the year, be sure of your eligibility to receive distributions from your business. If you accept more income than allowed, reconciling your K-1 is going to be a nightmare. A distribution may be taxable if the amount exceeds your tax basis in the partnership immediately before disbursement.
It is not up to the company to keep track of each owner’s stake in the company. It is too difficult to stay updated on activity like selling shares, or new owners entering the business halfway through the year. They are only responsible for the management of profit and loss as a whole.
Partnership K-1 Tax Basis: Inside vs Outside Basis
Unlike incorporated entities, partners pay tax on the partnership earnings regardless of whether money is distributed or retained in the business. Partnership K-1 tax basis has two forms: inside and outside basis.
Think of inside basis as belonging to the partnership entity as a whole. Inside basis is the total value of the business being broken down and passed to each partner. Now, outside basis is each partner’s share in the business based on their personal investment.
On day 1 of the partnership, outside basis is equal to each partner’s assets in the business, thus it is equal to inside basis. As the business starts to earn money outside basis adjusts due to partners retaining profit in the company for reinvestment, taking distributions, taking out a loan, etc. So partners must keep track of any adjustments to their ownership basis.
These items could affect a partner’s outside basis:
Increases Outside Basis
An increase in the share of either recourse or nonrecourse liabilities
Contributions of property or money including partnership liabilities
Share of taxable partnership income, including capital gains
Share of tax-exempt income
Decreases Outside Basis
A decrease in the share of partnership liabilities
Distributions of money and property including share of partnership liabilities
Share of partnership losses, including capital losses
Share of expenses that are not tax-deductible or capitalized
How To Calculate Partners K-1 Tax Basis
You should be keeping accurate records of your activity in the partnership. Gather all your records and determine your tax basis in the partnership at the end of each year. This is a tricky calculation and we highly recommend doing this with an accountant.
- First, you take your tax basis on the very last day of the prior year. It is zero if it is your first year in the partnership, it cannot be less than zero.
- Add (+) Money and any percentage of property contributed to the partnership minus any associated liabilities.
- Add (+) Your increased share of partnership liabilities minus your share of liabilities from the prior year.
- Add (+) Your share of the partnership’s income or gain (including tax-exempt income).
- Add (+) gains on property contributions (gains from the transfer of liabilities are NOT included).
- Add (+) Your share of excess deductions for property depletion (other than oil and gas depletion) over the property’s adjusted basis.
- Subtract (-) Withdrawals and distributions of money and the adjusted basis of property distributed to you from the partnership (property distributions part of your taxable income are NOT included).
- Subtract (-) Your decreased share of partnership liabilities minus your share of liabilities from the prior year.
- Subtract (-) Your share of the partnership’s nondeductible expenses that are NOT capital expenditures (excluding business interest expenses).
- Subtract (-) Your share of the partnership’s losses and deductions. Including capital losses, your share of a section 179 expense deduction for this year, and business interest expenses.
- Subtract (-) The amount of your deduction for depletion of any partnership oil and gas property, not to exceed your allocable share of the adjusted basis of that property.
- The sum (=) is the partner’s total K-1 tax basis.
Partnership Limitations For Schedule K-1
There is a limit to the amount of loss, deductions, and credits that owners can take on a K-1. To file a distributed loss you are limited by these 3 rules: basis limitations, at-risk limitations, and passive loss limitations.
Basis Limitations
Basis limitations mean that you can’t file a loss, deduction, or credit that is over your outside basis in the company. To determine your adjusted basis in the partnership for the year, use the basis calculation in the previous section. Do NOT use your capital account balance for your limitations. Your capital account is a reflection of inside basis in the company, different from outside basis.
Upon determining your tax basis in the partnership, if you have suffered a loss exceeding your basis it will be disallowed for the year. This means you won’t be able to claim the excess loss on this year’s taxes. Not to worry, you can carry the loss over indefinitely and take it in another year, so long as it isn’t more than your outside basis for that year.
At-Risk Limitations
If your partnership distributed a loss that resulted from an investment, you may be limited by how much you can file. Any investment (ex: a new machine or acquiring a new branch) has a calculated risk for each owner, called an at-risk basis. At-risk basis is calculated at the end of each year by combining a partner’s investment share with any financing or liabilities connected to the investment. Similar to basis limitations, a partner cannot deduct a loss over the amount contributed to a specific investment opportunity.
Passive Loss Limitations
A distributed loss is limited if you are a silent partner. When you are a passive owner and you incur a loss, you will need to go through the Instructions on Form 8582 or the Instructions on Form 8582-CR, to see if your deductions, losses, and credits are limited. These generally do not apply to partners who materially participate in the business.
S Corp Owners Tax Basis
S Corp shareholders start with basis equal to their initial contribution. When there is income cost basis goes up, when there is a loss/deduction/distribution, cost basis goes down. Anything that causes a fluctuation of inflows and outflows will create an adjusted basis.
A shareholder needs to make sure they have basis before they accept income or loss from a K-1 on their individual tax return. Anything taken in excess will result in a reclassification of non-taxable distributions as taxable dividends. This is like being double taxed in a C-Corporation, only with some nasty repercussions. A penalty would be assessed and there would be a reporting imbalance in owner equity for the S Corporation.
S Corp K-1 Tax Basis Formula
Monitoring personal tax basis is the shareholder’s responsibility. The S Corporation keeps track of basis for the business as a whole. It is too difficult to track the tax basis for every shareholder, so regulations state that shareholders be self-sufficient and maintain their own basis calculations.
IRS regulations are very clear on how to calculate tax basis for S Corp owners. All activity of an S corporation will be noted on the K-1. An owner needs to calculate their adjusted basis, by starting with the value of their initial investment and be proactive throughout the year when accepting distributions.
Here is how to calculate tax basis in an S Corp:
- First, you take the shareholder’s tax basis on the very last day of the year
- Add (+) basis for income items including tax-exempt items
- Add (+) basis for all non separately stated income items
- Subtract (-) non-dividend distributions of cash or property, not included in wages
- Subtract (-) share of all loss and deduction items separately stated including Section 179 deductions
- Subtract (-) share of all non-separately stated losses
- Subtract (-) share of all non-deductible expense and non-deductible fines and penalties
- The sum (=) is the total tax basis of a shareholder
K-1 Income Basis Reporting
K-1 income needs to be filed on your individual taxes each year. Without accurate reporting, you run the risk of penalty for misstating your share of a business and will need to make an amended return. Remember regardless of whether you have basis to take a loss or gain, your tax filing must match what is reported on your K-1. If you need help with a K-1 reconciliation we perform customized calculations for partners and S corporation members each year.
