So you get a K-1 every year at tax time, but do you know what that form is really all about?
If you are a shareholder in a Subchapter S corporation (S-corp), or have an interest in a partnership or LLC, you will likely receive a Schedule K-1 tax form from your corporation. This form shows the income, losses, credits and distributions made by the corporation during the previous tax year.
Because S-corps and LLCs are set up so they can pass their tax liability from the corporation to the shareholders, you, as a shareholder, get to foot the tax bill on your portion of the corporation’s taxable income. Even if you are not a corporate shareholder, you may still get a K-1 if you inherited cash or property through a will or trust if any inheritance taxes are owed or if you receive annual income from a trust.
Even though K-1’s look simple, you cannot simply transfer figures directly from boxes on the K-1 to boxes on your 1040 or 1041. That would be way too easy, right? How those numbers are transferred and where they are reported on the appropriate forms depend on several things, including what you paid for certain assets (your basis) and your level of activity in the corporation.
It is important that you communicate clearly with your tax professional about your activity in the corporation so that s/he can accurately complete your tax return. It’s equally important for you to understand how those K-1 numbers can impact your tax bill.
So, what do you need to know about a K-1, and what should you communicate to your tax preparer? Here are four key things:
- Timing – You won’t get your taxes done early. Subchapter S and LLC returns won’t get done until March 15th or so, so you (or your accountant) won’t be able to work on your own return until mid-March at the earliest. That gives you only one month until the April 15th tax deadline to get your return done. Be patient, and be prepared to file for an extension, if necessary.
- Passive activity – If you don’t materially participate in the corporation’s business activities during the year, your share of income and losses will be treated as passive activity. For example, my family operates an S-corporation farm in a state thousands of miles away. I am a shareholder, but I do not actively work on, make decisions about or financially contribute to the operation of the corporation. My K-1 income and losses will be reported as passive activity, which means my K-1 figures are reported in different ways on different forms from those with active participation. (The exception to this rule is if the corporation has rental activity. Rental income is passive unless you are a real estate professional and you meet certain other requirements. Yes, it’s complicated!)
- Alternative Minimum Tax (AMT) – Huh? The AMT is a parallel tax that increases the amount of income taxed by disallowing certain deductions and adding income that would normally be tax-free under the normal tax system. It was designed back in 1969 when Congress learned that 155 very wealthy people were paying NO federal income tax at all. The AMT keeps people from finding loopholes that help them avoid paying federal taxes, but sometimes it affects middle-income families as well, and surprise income from a K-1 can push the boundaries of the AMT. There are 27 lines of potential adjustments to your income on the AMT form, including passive activities, hoe equity interest, depreciation, and some things that you probably never heard of. Because it is extensive and complicated, seek help from a tax professional to be sure you get the best possible tax breaks you can here.
- More forms – Last year my small income from passive activity in my family’s little S-corp farm resulted in no less than 8 additional forms and worksheets in my tax return. That translates to more work and more expense in preparing your taxes. There’s nothing simple about filing taxes that include a Schedule K-1, so paying a little more to a trustworthy professional is totally worth it!
The bottom line is this: being a shareholder/part owner in a corporation or inheriting money from a trust makes your tax filing much more complicated. So, if you get that K-1 in the mail, be smart. Get some professional help to learn how to deal with it, and you may be able to minimize your tax liability and breathe a sigh of relief while someone else fills out all those worksheets!