A primary benefit of a "pass-through business structure" is the ability of its owners or shareholders to avoid double taxation. When a business adopts this structure, it's taxed at the ownership level, rather than at the ownership and business-structure levels. As a result, all organizational revenues and expenses, income and losses, tax deductions and tax credits, and any tax liability are distributed, or passed through, to the tax returns of the organization's owners or shareholders.
When a pass-through business structure is in place, the organization reports both its top-line and partner- or shareholder-level taxable earnings to the Internal Revenue Service (IRS) using the Form 1065 and a K-1 filing for each partner. In turn, the owner(s) or shareholder(s) report their pass-through business structure earnings and tax liabilities per the K-1 filings, along with other earnings, tax credits and tax deductions, using the appropriate IRS form for their tax return.
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Consider also: How Is K-1 Income Taxed?
Tax Effect of Pass-Through Business Structure
A pass-through or flow-through entity business structure treats business income as the income of the business entity's owners or shareholders. As such, the income is not subject to corporate tax, or a direct tax that's imposed on the income of an organization. Instead, an income tax is imposed on the earnings that originate with the pass-through entity but are distributed to each owner or stockholder of the organization in line with the relevant ownership agreements.
For instance, a partnership is a pass-through business structure whose partners may be individuals or business entities or some combination thereof. Each partner, rather than the partnership, incurs a tax liability on a share of the partnership's taxable income for the tax year, whether the partnership distributes that income or not.
What Is an IRS Schedule K-1?
The Schedule K-1, which an organization distributes to each partner or shareholder of a pass-through business structure, is the basis of the organization's IRS Form 1065, U.S. Return of Partnership Income. Whereas the entity submits the Form 1065 to the IRS as a means to report its net income, it provides a Schedule K-1 to each partner or shareholder to inform them of their share of the organization's profits, losses, tax deductions and tax credits.
Those who receive the Schedule K-1 use the figures therein to report that portion of their taxable income to the IRS. Although K-1 recipients don't file the schedule with their tax returns, they do rely on the schedules to calculate the tax liability they must report to the IRS.
Schedule K-1 Instructions for Partnerships
Partnerships with the following business structures must complete both a Schedule K-1 for each partner and an IRS Form 1065 Partnership Tax Return for the partnership itself:
- General Partnership
- Limited Partnership
- Limited Liability Partnership
- Limited Liability Company that's elected to be taxed as a partnership
A partnership produces a Schedule K-1 for each partner as the organization prepares the Partnership Tax Return, Form 1065, the latter of which it submits to the IRS to report the partnership's total net income. Similar to the IRS Form 1099, the Schedule K-1 reports the taxpayer's earnings, which originate with a partnership, for a tax year.
Consider also: Where to Report Schedule K-1 on a Personal Tax Return?
Other Entities That Issue the Schedule K-1
S corporations and some exchange traded funds (ETFs) issue the Schedule K-1 for the same purpose as do partnerships, namely to notify the IRS and shareholders of their earnings, losses, tax deductions and credits. What's more, a trustee prepares a Schedule K-1 for trusts and estates for which income has been distributed to beneficiaries.