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The Schedule K-1 Form Explained

Source: IRS.

If you've ever invested in a business that uses one of several different types of legal structures, such as partnership, "C" corporation, or LLC, then you've probably received a Schedule K-1 in the mail during tax season. And while MLPs and LLCs are able to pass more income on to investors because they don't pay corporate income taxes, it adds another layer of complexity for the shareholder/partner. You may also get a Schedule K-1 if you're the beneficiary of a trust or an estate.

Let's take a closer look at the Schedule K-1 form, the implications for you, and what you must do with it.

The pros and cons of trusts, partnerships, S corps

For investing purposes, MLPs and LLCs can be a great way to maximize the amount of cash that can be paid to investors, because these organizational structures don't pay income tax, but pass that burden along to those who are invested in it. The same goes for some trust structures.

In other words, because these entities don't pay corporate taxes, the full burden falls on those receiving income from them. This differs from dividend income paid to shareholders by a typical corporation in that regular dividends are taxed as long-term capital gains, while much of the income paid and shown on a Schedule K-1 can be classified as regular income. That means it's taxed at your effective income-tax rate, which is often much higher than the 15% or 20% long-term capital gains rate for corporate dividends.

In summary, a Schedule K-1 issuing entity may be able to pass more income along to you, the investor, but you may end up giving more of it back in taxes than if you'd received regular dividends from a corporation. It really boils down to your tax rate, and how much more income the LLC, MLP, or trust is able to pay.

Different Schedule K-1 forms, and what they're for

There are three Schedule K-1 forms: The Form 1041, which is for beneficiaries of an estate or trust:

Form 1065, which is for partners in a master limited partnership, or LLC:

Source: IRS.

And Form 1120S, for "S" corporations:

Source: IRS.

These Schedule K-1 forms are much like a 1099 or W2 in that it's something you'll receive from the trust, estate, LLC, S corp., or partnership, breaking down your share of the income into the various categories under which that income falls. This matters, because different kinds of income may be taxed as capital gains, or as regular income, and you want to be sure to pay the appropriate tax rate -- especially the lower capital gains rate.

Source: IRS.

It's also a little different from a W2 or 1099, which only report income paid to you. If you're getting a Schedule K-1 form from an entity you partly own, you may also be able to claim a share of the losses, deductions, and credits, as well as your share of the income.

What you need to do with it

It's just like any other tax-reporting document you get before tax season: You need to report it when you file your taxes, and for two reasons:

  • It's taxable income.
  • It's already been reported to the IRS by the entity that paid you, and they'll notice if you omit it when you file taxes.

It's highly advisable that you either go to a tax professional, or at least use reputable tax-filing software if you're getting any of these Schedule K-1 forms. Not only will this simplify the process, but the cost to do so is well worth it, just in the time you'll save versus trying to do it by hand. This is especially true if you have multiple Schedule K-1 forms.

It's about the big picture

If you're getting a Schedule K-1 form because of a windfall such as an inheritance from an estate, or as beneficiary of a trust, it's just the way it is. But if you're receiving them due to investments in LLCs, partnerships, or a "C" corp, you should look at the bigger picture.

Those entities are able to pay you more income because of their legal structures, but you'll probably pay more tax on your end. In some cases, you'll also get a share of the losses, deductions, and credits, as well. In other words, there are numerous potential benefits to these kinds of structures.

There are trade-offs, too. You'll have more complex -- and potentially more costly -- tax preparation each year. If you're only getting a small amount of income because of a minimal investment in a few shares of an MLP or LLC, it may not be worth it.

But if it's a major source of income, such as being co-owner of your business, then it's obviously a different situation entirely. Whether the income you get from these investments is worth the cost and headache is something you'll have to determine based on your situation.

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The article The Schedule K-1 Form Explained originally appeared on Fool.com.

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