Appendix K-1 is how individuals report income from businesses they own. The Ascent will walk you through completing and submitting the form.
You may have heard about the Schedule K-1 form when a banker requested it or your personal tax preparer asked for it. It’s the small business owner version of the W2 form that you send to regular employees and the 1099 that you send to contractors.
The K-1 shows how much of the trade tax for the year you have to report on your personal return and how your personal capital account in the company has developed over the past year.
Read on to learn more about how to use the K-1 and how to prepare your own.
Overview: What is the Schedule K-1 tax form?
The K-1 tax form is a supplemental form that helps small business owners file their personal taxes. The form reports income and other information about the company and you use it to fill out your personal declaration.
The form is for pass-through units only. General partnerships (which are filed on Form 1065) and S corporations (IRS Form 1120) are the two business entities that pass income to owners that is reported on personal returns.
You may want to bookmark the Schedule K-1 how-to page on the IRS website as the form changes every year.
K-1 are also used for trusts and estates. You may have experience with them if you have ever had money left in a will. The numbers are reported in the same personal return schedule.
Who Must File a K-1 Form?
There is a two-part answer to this question. The company must complete and send the form to all owners of the company and the owner must use the information to complete the personal declaration and then officially submit it.
How to submit a Schedule K-1 tax form
Here are the steps to fill out a K-1 form.
1. Fill out the trade tax return
Before you can start with the K-1, fill out the trade tax return with your tax software. The information you enter into the K-1 comes from the business statement.
Many pass-through businesses distribute necessary cash to owners to pay taxes. Be sure to keep the Distributions and Schedule M of the Business Statement up to date as you will need this information for the K-1.
2. Complete Parts I and II of the form
In parts I and II, the letters A-K only have to be filled out once and can then be carried over from year to year provided there is no change of ownership. Each of these items contains administrative information that you can find in the entity documents you filed with your state if you don’t remember it off the top of your head.
Things start to get interesting in section L.
You can find the net income for the current year on the front of the trade tax return. The other items are in Appendix M-2 of the partnership tax return.
The last two sections in Part II deal with the contribution of property to the company as equity. If you have done so and the property had an unreported gain when it was brought in, tick ‘Yes’ and state the amount of the gain.
3. Complete Part III of the form
Things start to get complicated in Part III. Let’s go through it and talk about which sections might be applicable to your business.
- 1. Enter the same title page number as in section L.
- 2nd-3rd Complete this if the business has received rental income from real estate.
- 4. Guaranteed payments are payments to partners regardless of the company’s income.
- 5th-10th These sections relate to income from various investments made by the company that are not related to its operations.
- 11. Other income generated by the company that is not related to the ordinary course of business. The IRS’ specific instructions provide codes to use for each type of income.
- 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 fill them in, a form has been printed out with your business statement.
- 19. Enter the result from section L in part II.
- 20. The guidance page above provides a list of what would need to be reported in the Other Information section.
4. Submit the form to the owners
When mailing the final business tax return to the other owners, attach Exhibit K-1 to the return.
5. Attach your personal tax returns
The most important key figure for your return is the net operating income. This number will be included in the tax schedule E section of the personal declaration.
Other items to keep in mind are capital gains that must be reported in IRS Schedule D and distributions that your bank will be interested in.
How Do Banks Use K-1 Forms?
Banks are primarily 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 require an even higher ratio. The bank pulls the distribution number from either the K-1 or Schedule M on the business statement and subtracts it from the free cash flow.
It is deducted because any money paid out from the business is deemed unavailable to pay business debts.
Distributions can also help with business loans. If you own multiple businesses, the bank requests K-1s from each business and adds the payouts to your personal income in their credit analysis.
It can be a balancing act to allocate enough income to make the owners’ investment worthwhile and keep the banks happy with the money in the business.
It is a good idea to set an amount in the articles of association that will be distributed annually (e.g. half of net income after tax) and stick to that figure. If the bank refuses, you can refer to the agreement and show that you are not allowed to pay any other amount.
When are K-1 forms due?
K1 filings must be mailed to owners at the same time as business tax returns by March 15 each year. If you are the sole owner of your business, the actual due date is if you submit your personal statement by April 15th.
Make your tax return A OK-1
The world of small business taxes can seem like an endless mountain of paperwork in which you act 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 to understand the information provided 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 has prepared and answer any questions your bankers ask.