CPE

Accounting Tips: Schedule K-1 Form 1065

December 3, 2024

7 min read

For tax professionals working with partnerships, you need to know how to navigate the complexities of Form 1065 and Schedule K-1. To help you, we’ve written a guide on how to accurately complete these forms, detailing the necessary financial information, types of liabilities, and how to properly classify activities.

What is Form 1065

Form 1065 is a six-page document that will require information from a variety of business financial documents (e.g., income statement and balance sheet) in order to be completed by the practitioner. Form 1065 is an information return, which is a type of return that is used simply to report information to the IRS. It differs from other tax returns (e.g., Form 1040) as it does not report a tax due. Form 1065 in essence is used to report the income, gains, losses, deductions, credits, and other information from the operation of a partnership.

A partnership is a business arrangement where two or more owners contribute money, labor, property, or skills and agree to share profits and losses. There are several types of partnerships, including general partnerships, limited partnerships, and limited liability partnerships. In a general partnership, all partners are personally liable for entity-level debts. In a limited partnership, some partners have limited liability. Form 1065 must be filed by the 15th day of the third month following the date the tax year ended (March 15 for a calendar-year partnership). However, the filing date may be extended by six months.

What is Schedule K-1 Form 1065?

Schedule K-1 Form 1065 is an IRS form used by partnerships (as well as S corporations, and estates and trusts) to declare the income, deductions, and credits that partners, shareholders, and beneficiaries have received during the tax year. Taxpayers, in turn, transfer the financial information on their K-1s to their own tax returns.

Now let’s look at the Schedule K-1 itself.

Schedule K-1 Part 1

Part I of Schedule K-1 asks for the general information of the partnership (i.e. name, address, IRS center, etc.). This information will flow from the tax return itself and shouldn’t be an issue.

Schedule K-1 Part II

Part II asks for information about the partner. Besides the partner name and identifying tax number, this part of the form asks for:

The type of partner (i.e., General or Limited, Foreign or Domestic)
The Profit, Loss, and Capital ownership percentages of the partner at the beginning and end of the tax period in question
The partner’s share of liabilities.

It is important that the client send the partnership agreement so that the practitioner can easily check this information. Yet another good practice is to import this information into the return from an excel spreadsheet that has already been verified.

Types of liabilities

It is important to bear in mind the type of liabilities for which each partner is responsible.

Recourse debt is a type of secured loan that allows the lender to seize collateral and other assets of the debtor. It provides protection to lenders and is considered less risky for them.
Nonrecourse debt is a loan where the borrower's liability is limited to the collateral pledged. The lender cannot pursue the borrower's other assets if they default on the loan.
Qualified nonrecourse debt is a type of debt for which no one is personally liable for repayment that is borrowed for use in an activity of holding real property and that is loaned or guaranteed by a federal, state, or local government or that is borrowed from a qualified person. In a qualified nonrecourse debt agreement, both the lender and borrower are qualified, meaning they are legally allowed to engage in a contract. Qualified nonrecourse debt allows a qualified person to forego personal liability for repayment of the partnership’s debt.

Recourse and qualified nonrecourse debt are the two types of financing that increase the at-risk basis against which the partner can take a loss, so it is important to understand the types of liabilities and make sure they are adequately reflected on the tax return.

Passive or nonpassive activities

Yet another consideration when completing Schedule K-1 Form 1065 is the classification of the activity as passive or nonpassive.

Passive activities include trade or business activities in which the taxpayer does not materially participate. Passive activity losses are limited to each partner’s other passive income.
Nonpassive activities are defined as one in which a taxpayer materially participated in the activity that resulted in an income or loss. There are a number of tests that determine if an activity is nonpassive. It is far easier for a taxpayer to take advantage of nonpassive activity losses.

This part of the form also requires detailing the Partner’s Capital Account Activity in Box L. This is a summary of the activity in the partner’s account. For example, the form asks for how much capital was contributed during the year, net income and loss as well as withdrawals and distributions. The total of the ending capital ending accounts must reconcile to the rest of the tax form. Most, if not all, software programs will generate a diagnostic error when the return is out of balance.

Boxes M&N pertain to built-in gains and Section 704(c). Briefly, built-in gains refer to the excess of the fair market value over the tax basis of an asset as of the contribution date, and Section 704 (c) is a tax code provision that prevents the shifting of tax items among partners when a partner contributes property with a fair market value different from its tax basis to a partnership.

Schedule K-1 Part III

Part III of the Schedule K-1 details the partner’s share of current year income, deductions, credits, and other items. Most of it is self-explanatory and items that appear here generally will flow from the Schedule K (page 5) of the Form 1065 itself. These include such common items of income and expense as interest income, qualified and ordinary dividends, royalties, short-term and long-term capital gains, Section 179 deduction, self-employment earnings, AMT items, tax-exempt income, distributions, rental income, and foreign taxes paid.

However, this part also breaks out ordinary business income, guaranteed payments for services and capital, unrecaptured Section 1250 gain/loss, and other income/loss. Ordinary business income encompasses any income realized as a result of an entity’s operations. In its simplest form, it is a business entity’s net profit or loss, which is calculated as its revenue from all sources minus the costs of doing business.

Guaranteed payments are generally paid to partners for their time or capital they have made available to the partnership. A partner who receives guaranteed payments may be subject to self-employment tax. Partners who are not considered limited partners may also be subject to the self-employment tax on their distributive share of ordinary business income.

In 2021, box 16 was added to the Schedule K-1 to indicate the attachment of Schedule K-3 for items of international income, deduction, or credit. The purpose of the form is to provide additional guidance to partners as to how to calculate their U.S. income tax liability based on these international items.

One important aspect of the Schedule K-1 to point out is the other Information in box 20. This is typically where the practitioner will add footnotes. There are an abundance of footnote codes and they direct the partner as to where he or she should show credits, as well as items of income and expense on their own tax return. Many practitioners will use footnotes to report information on the Section 199A Qualified Business Income Deduction and separate municipal income by state so that ultimately the partner receiving the K-1 can file a more accurate return and have a better sense of what the partnership is doing and how it is performing.

Final thoughts on Schedule K-1 Form 1065

The Schedule K-1 is relatively straightforward but nonetheless can be challenging to practitioners when considering how important it is to properly classify the type of partner, type of income, and the type of debt. If an error is made in any of the aforementioned categories, the damaging effect to the client can be considerable (as well as the impact to the client/tax preparer relationship). Given the increased popularity of private partnerships (e.g.., hedge funds, private equity funds, real estate funds), practitioners need to focus their attention on this important form and its proper handling.

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