You may have heard of the Schedule K-1 form if a banker requested it or your personal tax return preparer asked for it. It is the small-business-owner version of the W2 form that you send to normal employees and the 1099 that you send to contractors.
The K-1 shows how much of the business taxes for the year you must report on your personal return as well as how your personal capital account in the business changed over the last year.
Read on to learn more about how the K-1 is used and how to prepare your own.
Overview: What is the Schedule K-1 tax form?
The K-1 tax form is a supplementary form that assists owners of small businesses in filing their personal taxes. The form reports the income and other information about the business and you use it to complete your personal return.
The form is only applicable to pass-through entities. General partnerships (which file under form 1065) and S corporations (IRS form 1120) are the two business entities that pass income through to owners to be reported on the personal return.
K-1s are also used for trusts and estates. You may have experience with them if you have ever been left money in someone’s will. The numbers are reported in the same schedule of the personal return.
Who has to file a K-1 form?
There is a two-part answer to this question. The business is required to complete the form and submit it to all owners of the business, and the owner is required to use the information to complete the personal return and then officially file it.
How to file a Schedule K-1 tax form
Here are the steps to completing a K-1 form.
1. Complete the business tax return
Many pass-through businesses will distribute the necessary cash to owners to pay taxes. Make sure you keep the distributions and the Schedule M on the business return up to date because you will need that information for the K-1.
2. Complete Parts I and II of the form
In parts I and II, letters A–K only need to be completed once and then can carry over from year to year unless there is a change in ownership. Each of these items feature administrative information that you can find in the entity documents you filed with your state, if you don’t it remember off the top of your head.
Section L is where it starts to get interesting.
Current year net income is found on the front page of the business tax return. The other line items are on the Schedule M-2 on the partnership tax return.
The final two sections in Part II have to do with contributing property to the business as equity. If you have done that and the property had an unreported gain when contributed, check "yes" and declare the amount of the gain.
3. Complete Part III of the form
Part III is where it starts to get complicated. Lets run through it and talk about which sections may be applicable to your business.
- 1. Fill in the same front page number as you did in Section L.
- 2.–3. Complete these if the business had rental real estate income.
- 4. Guaranteed payments are payments made to partners regardless of the income of the business.
- 5.–10. These sections are for income from various investments that the business made not related to its business operations.
- 11. Other income that the business earned that was not related to normal business activities. The contain codes to use for each income type.
- 12.–13. Other expenses, including accelerated depreciation.
- 14. If you own the business with your spouse, you must declare and pay self-employment taxes.
- 15.–18. Little-used sections. If you need to complete them, there will have been a related form printed along with your business return.
- 19. Enter the result from Section L in Part II.
- 20. The instruction page above has a list of what would need to be reported in the other information section.
4. Submit the form to the owners
When you send the final business tax return to the other owners, attach the Schedule K-1 to the return.
5. File with your personal tax returns
The most important number for your return is the business net income. This number will go into the tax Schedule E section on the personal return.
Other items to keep track of include capital gains to report on IRS schedule D and distributions that your bank will be interested in.
How do banks use K-1 forms?
Banks are mainly concerned with the debt service coverage ratio, which is typically calculated as follows:
(Free Cash Flow − Distributions) ÷ Debt Service
The Small Business Administration requires a ratio of at least 1.15, and many banks will require a ratio even higher than that. The bank will pull the distribution number either from the K-1 or the Schedule M on the business return and subtract it from free cash flow.
It is subtracted because any money distributed out of the business is considered unavailable to pay down business debt.
Distributions can also help on business loans. If you have ownership in several businesses, the bank will request K-1s from each business and will add the distributions to your personal income in their credit analysis.
It can be a balancing act between distributing out enough income to make the investment worth it for owners and keeping banks happy with the cash in the business.
A good practice is to set an amount that will be distributed each year (e.g. half of after-tax net income) in the partnership agreement and stick to that number. If the bank balks, you can point to the agreement and show that you are not allowed to distribute any other amount.
When are K-1 forms due?
K1 filings are due to be sent to owners at the same time as business tax returns on March 15 each year. If you are the sole owner of your business, the true due date is when you file your personal return by April 15.
Make your tax return A OK-1
The world of small business taxes can seem like an endless mountain of paperwork with you acting as Sisyphus pushing paperwork up the hill only to be eaten by IRS vultures at the end of the day.
The first step to feeling in control of your taxes and getting back to your business is understanding the information that is reported on each form. After reading this article, you should be able to either prepare your own K-1s or be able to understand what your CPA prepared and answer any questions your bankers ask.