If you have joined a business partnership, limited liability company or S corporation, you will receive a report of your share of the firm's net income on Schedule K-1, also known as IRS Form 1065. The company shares this information with the Internal Revenue Service, and you must report the earnings on your individual tax return. For anyone participating in a business as a shareholding partner, the annual K-1 is an extremely important document.
The K1 Form and Tax Consequences
A business formed as a partnership, limited liability company or S corporation does not pay income taxes on the money it earns. Instead, the business passes its earnings to its partners, proportional to the percentage of shares each partner holds. The partners in the business report this "pass-through" income on their individual income tax returns and pay tax according to their net income. Note that the IRS considers partnership shares to be earning income even if the business reinvested the money and didn't actually pay it out to the partners.
A pass-through business reports the net earnings to the IRS but does not pay income tax on the earnings. Instead, the IRS requires the return for informational purposes, and the agency verifies that each partner has accurately reported the income. IRS rules require that companies issue their K-1s by March 15 or the 15th day of the third month of the company's tax year, if it doesn't use the calendar year; if they have been granted an extension of time to file, the deadline for the K-1 is extended by six months. The form gives each partner's share of earnings but does not have to be submitted to the IRS with Form 1040. You do, however, report any K1 income on a 1040 that you file.
Not all recipients of the K-1 form are active business partners; some are not even aware of their partnership status at all. If you've invested in a mutual fund or other vehicle that operates as a partnership, your earnings from the investment may be calculated according to your shares, and you may receive a unexpected K-1 in March. This is also true of trusts that pay beneficiaries yearly income according to proportions set out in the trust documents. Although you don't have to submit Form K-1 to the IRS, the fund or trust manager has reported the payout and you must add it to your declared income.
Special Cases for Reporting Schedule K 1 on Form 1040
The IRS has a rather complicated set of instructions on how to report the income or loss from a Form K-1. It depends on whether the business had a gain or loss, and whether or not the earnings were derived from passive investment or active participation in the company. In most cases, ordinary pass-through income (or loss) from a partnership, LLC or S corporation goes on Schedule E, Line 28. However, if the earnings were paid in the form of dividends or interest, then you report them on Schedule B. Capital gains or losses are reported on Schedule D.
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