How is your NCAA bracket doing this year? As per usual, mine is completely busted. Hopefully you still have your Final Four teams still intact. Anyway, this week I wanted to start to cover the impact of a Schedule K-1 on your taxes. I think it is safe to say most business owners and people out there have heard of a K-1. It is also safe to assume that most do not understand what the K-1 is actually “saying” with regards to your taxes. I am going to focus this article on the informational sections of the K-1 (Parts I and II). Next week I will discuss Part III, which is the “numbers” section, and the footnotes.
Part I – Information About the Partnership
This section provides with you with basics about the K-1’s issuing partnership. Included in this section are the name, mailing address, and EIN as well as where the partnership tax return was filed.
Lastly, this section notifies you if the partnership is a Publicly Traded Partnership (“PTP”). If this box is checked, the tax treatment of the items in Part III (generally losses) are treated substantially different than if the partnership is not a PTP. I’ll save a more detailed discussion of PTP’s for another time as it is quite complex.
Part II – Information About the Partner
This section provides your personal information and how you participate in the partnership. First you will see your SSN or EIN (if your business received the K-1) as well as your full mailing address.
Immediately following this is your status as a partner in the partnership. If you are actively involved in the partnership, you will generally be a General Partner or LLC Member-Manager. If you are a “silent” owner or investor, you will generally have the Limited Partner or Other LLC Member checked off.
Next up is your ownership and income/loss sharing percentages. These percentages should generally match what is stated in the original or amended partnership agreements. As an FYI, the capital percentage should be based on the amounts you would receive if the partnership completely liquidated.
Section K shows your share of the partnership’s liabilities at year-end. This section gets overlooked by most K-1 recipients but should be a focal point of your discussion with your tax preparer every year. Reason being is that if you have cumulative and/or current losses in the partnership, recourse and/or qualified nonrecourse debt may provide you a way to utilize these losses against your taxes. This is an extremely complex tax issue which can take days to discuss, so we will save this for another time.
Moving to Section L, this is your capital account in the partnership. This represents your share of income and/or losses as well as the capital you infused and withdrew since inception of your partnership interest. The next part of this section details how your K-1 is presented – Tax basis, GAAP, Section 704(b), or Other. Tax basis, in general, reports all transactions that affect the tax situation of the partnership. If GAAP is checked, this means the K-1s are prepared in accordance with Generally Accepted Accounting Principles. If 704(b) is checked, the K-1 discloses the “substantial economic effect of the allocations amount the partners”.
Lastly, Section M is required information if you contributed property with a built-in gain or loss to the partnership. For example, if you contributed a parcel of land to the partnership with a fair market value of $1,000,000 but you purchased it for $500,000, the Yes box would be checked. This information is vital to the allocation of gains and losses by the partnership when the property is sold [see Section 704(c)]
So why did I take time out to talk about these sections of the K-1? Well, most clients that I have had in the past typically overlook them and focus on Part III of the K-1, which includes your tax amounts for the year. The information provided in Part II can have a dramatic effect on how the income and deductions are reported on your taxes. In turn, this can drastically change your tax refund or payment. I cannot emphasize enough to make sure all of the data discussed above is 100% accurate. Make it a point this year to have an in-depth discussion about all the items on your K-1. You have nothing to lose and potentially a great deal to gain!
As always feel free to contact me with questions.