Schedule K-1 is one of the most complex tax forms that an investor is ever likely to see. It's hard enough to understand from a federal income tax perspective, but when you add in the implications of state income tax systems in multiple states, K-1s can become daunting. With some effort, though, you can figure out how to handle K-1 income for another state without causing yourself a big tax headache.
Why you get K-1s in the first place
Investors in master limited partnerships and other business interests that are formed as pass-through entities, like limited liability companies or partnerships, generally have to pay taxes on the income that their investments generate. Although the entities themselves don't pay tax, their taxable characteristics get carried out to individual investors. The Schedule K-1 form gives specific details on the income and deductions that the investment generates, and where you need to include them on your federal return.
When the business you invest in only operates in the state where you reside, then the taxable income for state tax purposes will generally be the same as it is for federal purposes. It's only when the business operates in other states that you have a potential issue. Unfortunately, this is an increasingly common issue, especially with the rise in popularity of master limited partnerships in the energy industry that have properties scattered across the country.
Dealing with nonresident tax liability
The first step is to figure out exactly how much income you have in each state in question. Sometimes, the partnership or LLC itself will break down all of your income by state, sending you multiple schedules that allocate appropriate income and deductions by the place where they were generated. In other situations, you might receive information on the percentage of total income and deductions allocable to each state. That will require you to do the math yourself, taking the federal figures on the K-1 and allocating them by hand to the various states in question.
Once you've done that, the next step is to look at each state's rules governing filing requirements. In some states, if you earn less than a certain minimum amount, then the state doesn't require you to file a tax return. Above that amount, though, you might have to file as a nonresident and potentially owe money to that state for income tax on the income that's allocable to business activities there. If you don't, then you run the risk of having the state pursue you and charge interest and penalties for failing to meet the requirements.
Getting a credit
The good news, though, is that in many cases, your home state will give you a credit for income tax paid to another state. You won't always get the full amount back, as many states limit your credit to the amount that your home state would have charged on that income. In other words, if the other state charges higher taxes than your home state, you won't get a credit for the full amount.
Nevertheless, the hassle of dealing with other state income tax returns makes investments that involve K-1s more complex than ordinary stocks and mutual funds. The rewards can be worth the extra work, but it's important to know what you're getting into before you invest.
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