A partnership is referred to as a "pass-through" entity because its partners, rather than the partnership itself, pay taxes on the income of the partnership. All income or losses, tax deductions and tax credits are distributed, or passed through, to the partners who report those events on their personal tax returns.
Although a partnership is not subject to federal or state income taxes, each partner, including limited partners, incurs a tax liability on their share of the partnership's taxable income for the tax year. This is true whether or not the partnership actually distributed those earnings.
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How Is a K-1 Filing Used?
Schedule K-1 is, in effect, a supporting document for IRS Form 1065 U.S. Return of Partnership Income.While Form 1065 reports the partnership's profits and losses, tax deductions and credits to the IRS, each Schedule K-1 reports a partner's share of that partnership's profits, losses, deductions and credits. Partners use the information on Schedule K-1 related to their shares of a partnership's profits, losses, deductions and credits to report income to the IRS using Form 1040.
Who Provides a Schedule K-1?
A partnership provides the Schedule K-1 to its partners as part of the process of completing the Partnership Tax Return, Form 1065, which reports that partnership's total net income to the IRS. From the partner's perspective, the Schedule K-1 serves a purpose similar to that of the IRS Form 1099, in that both report taxpayer earnings for the tax year.
Likewise, S corporations, some exchange traded funds (ETFs) and limited partnerships create Schedules K-1 for the same purpose, namely to inform the IRS and corporate shareholders or partners of the individual's earnings, losses, tax deductions and credits. Trustees also prepare and file Schedule K-1 for trusts and estates for which income has been distributed to beneficiaries.
Partnerships Use K-1 and Form 1065
If you're a partner in any of the following entities, your company must complete both Schedule K-1 and IRS Form 1065 Partnership Tax Return for each partner:
- General partnership.
- Limited partnership.
- Limited liability partnership
- Limited liability company that's elected to be taxed as a partnership.
Although the Schedule K-1 is not filed with a partner's tax return, the partner relies on it to determine how much income to report to the IRS for the tax year.
How Do Partners Use Schedule K-1?
Partners use Schedule K-1 to complete their personal tax returns. Consequently, the K-1 Schedule serves as evidence of the validity of figures reported in a partner's return. Also, the K-1 Schedule validates the content of IRS Form 1065 U.S. Return of Partnership, which notifies the IRS as to a partnership's taxable income and, by extension, the partner's tax liability.
Issues With Schedule K-1
While many tax procedures can appear to be clear-cut, the receipt and use of the Schedule K-1 is not without issue. A partner must receive a Schedule K-1 to accurately report income to the IRS for the year. Unfortunately, the K-1 may be distributed as late as March in the tax reporting cycle, a fact that delays a partner's submission of their tax return to the IRS.
Calculating a partner's share in the partnership's taxable income can be a complex and time-consuming process. It's likely that the creation of a partner's tax return requires the inclusion of multiple entries from Schedule K-1, a process that can lead to errors if not done carefully.