Are K-1 Distributions Considered Taxable?

Schedule K-1 is a tax form that reports income, losses, and dividends. The K-1 can be used by partnerships, S-corporations, and trusts to report income, losses, deductions, credit, and distributions to their stakeholders and the IRS. Depending on the issuer, the information on the K-1 is used to complete Form 1065 (partnership tax return), Form 1120-S (S-corporation tax return), or Form 1041 (trust and estate tax return).

Are K-1 distributions taxable?

Sometimes the distribution reported on a K-1 is taxable to the recipient, but that determination depends on the type of distribution. For example, if the distribution is a return of capital, it is not taxable. However, if the distribution is income from the business, it is taxable. 

When used by a partnership, the tax obligation is affected by the partner’s basis in the partnership, which is determined by the capital contribution of each partner, as well as distributions. If the distribution is a return of capital the partner invested, it is typically not taxable. If the distribution is a portion of the partnership’s profits, it is taxable income.

How does a partnership work?

Partnerships, like sole proprietorships, are not separate entities for tax purposes. As a sole proprietor, you must pay taxes on your business' income. Similarly, a partnership is a pass-through entity that funnels profits and losses to each partner according to their ownership stake. Each partner prepares a K-1, regardless of whether the partnership is general or limited liability. However, the tax implications differ for limited and general partners because while limited partners do not pay self-employment taxes on their share of the income, a general partner does. 

In this case, there is a difference between preparing and filing. The taxpayer does not include a copy of their K-1 with their tax return. Instead, they use the information on the K-1 to complete the tax filing.

How are K-1 distributions taxed?

For general partners in a pass-through business, income distributed from the company is typically considered earned income, and the partner will owe income tax and self-employment taxes (both the employee and employer contributions to Social Security and Medicare) on the distribution. Since the partnership has already calculated expenses and income, the income (if any) reported to the partner on a K-1 is generally income. 

If the taxpayer is a trust beneficiary (non-grantor trust) rather than a partner, the trust still issues a K-1, which the beneficiary uses to complete their 1041. The distinction between grantor and non-grantor trusts is important because a grantor trust is a disregarded entity that would issue a grantor letter to the beneficiaries. 

What if the partnership records a loss?

If the partnership operates a business that experiences a loss, that loss is also reported to the partners using a K-1 and added to the tax return. In that event, the partnership can carry forward the loss and apply it against future partnership income distributions. Partners can accumulate sequential year losses to reduce future income.