Traditional corporations are the only form of business required to pay income tax on company profits. Other types of businesses allocate those profits to their owners, who are responsible for the taxes on those profits. Such companies use Schedule K-1 to tell individual owners how much of the business's profits or losses they're responsible for. Some estates and trusts also use Schedule K-1 to allocate profits and losses.
All companies except traditional corporations are known as pass-through or flow-through entities. That means that for tax purposes, their profits and losses "pass through" to the owners, who report them on their personal tax returns and, if necessary, pay taxes on them. In a sole proprietorship, there's only one owner, so business profits and losses all flow to that owner's return. In a partnership or an "S" corporation -- a special form of corporation that's taxed like a partnership -- the profits and losses get allocated among all the owners or shareholders. Owners must pay taxes on their share of the company's profit even if they didn't actually collect all -- or any -- of that profit.
Partnerships and "S" corporations don't have to pay federal income taxes, but they still have to file income tax returns. These returns tell the Internal Revenue Service how much the company made in profit -- or how much it lost. Along with their returns, these companies file a Schedule K-1 for each owner or shareholder. A particular owner's K-1 specifies how much profit that owner must report as income, or how much that owner can claim as a business loss to offset other income. If the company has any tax deductions that also flow through to the owners, these, too, are reported on the K-1. The owners also receive copies of their K-1 forms.
Forms and Reporting
Partnerships file a tax return using IRS Form 1065, while "S" corporations use Form 1120S. Each return has its own, slightly different version of Schedule K-1. Company owners and shareholders use the information from the K-1 when preparing their personal tax returns. Taxpayers with K-1 income or losses generally must file Schedule E with their tax returns. This schedule tells you how much to report and where to report it on your tax return. Owners of pass-through businesses must use Form 1040 for their tax returns. The simplified 1040A and 1040EZ forms don't allow for business income.
LLCs, Estates, Trusts
The federal government doesn't recognize limited liability companies, or LLCs, so they get taxed as sole proprietorships, partnerships, S corporations or regular corporations depending on their ownership structure and whether the company has sought corporate tax treatment. If you're a member of an LLC that's treated as a partnership or "S" corporation, you'll get a Schedule K-1. Some forms of estates and trusts -- but not all -- also pass profits and losses to their beneficiaries. These beneficiaries will get a K-1, too -- one tailored for use with Form 1041, the tax return used by estates and trusts. Beneficiaries who get a K-1 must file Schedule E with their taxes.
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