It’s that time of year when extended pass-through business returns are being finalized, and owners are beginning to receive their K-1s. If you are one of those owners, have you ever looked at your K-1? Do you know what information is being provided to you?
To move forward on explaining your K-1, we first must take a step back. Businesses that are structured as LLCs (that haven’t elected C status), partnerships or S corporations are all considered pass-through entities. The “pass-through” term was coined as all the income passes through to its owners to be taxed; the entity itself does not pay federal income taxes with the entity tax return.
So, how does the entity information get to the owners if the entity doesn’t pay tax? Enter the K-1. At its most basic function, the K-1 reports an owner’s share of the entity’s income, deductions, adjustments and tax credits. It essentially takes the entity return and carves it into pieces for each owner.
The ordinary income or rental income reported will be the net of ordinary/rental income and expenses for the entity. Items like interest income, dividends and capital gains are considered separately stated items, as they have separate places on your individual return that they need to go (Schedule B and Schedule D, for example). Same for separately stated expense items, like charitable contributions (Schedule A) or pension contributions (Schedule 1). In large part, you will be able to find each number on your K-1 in your completed 1040 tax return and accompanying schedules.
We are often asked, “Why doesn’t the net income match the cash I received during the year?” The distributions of cash you receive throughout the year are reported on your K-1, but, in many cases, this is not the exact same amount of income that you must report. When your distributions are less than the income you must report, this gives rise to what many refer to as “phantom income.” Historically, “phantom income” referred to unrealized investment gains, but today, it covers primarily any type of income you report that you did not receive actual cash for. There are several reasons that the cash distributed may be less than the income being reported, debt servicing for example, but ultimately it is a business decision for the owners. Often this decision is guided by the entity’s operating agreement. Some agreements have a set percentage, say 85% of income, while others have it stated as a tax distribution, maybe 50% of income. Many just leave it as completely discretionary. As you can see, it is prudent to have a strong understanding of these agreements especially when trying to reconcile income and cash.
On that note, we’ll talk about the importance of operating agreements in the next installment! I hope you have gained a little more insight into your K-1 and what it means.