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How do K-1s work?

Forum|Forum|6 years ago
June 1, 2019
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I have a K-1 from an investment. The distributions I received do not match my initial investment. However, when I enter the distribution it increases my taxable income, why is that? The way I view it, the initial investment was with after tax dollars, so the distributions are essentially my money coming back to me and I shouldn't have to pay taxes until I actually make more than my initial investment. I'm I viewing that correctly?

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Best answer by TomYoung

I have a feeling that you are not understanding the underlying concept of "partnerships", which I assume is the form of the ETF or whatever you bought.

"Schedule K-1 (Form 1065)" is the title of the Schedule K-1 used by partnerships, "Schedule K-1 (Form 1120S)" is the title of the Schedule K-1 used by Sub-S Corp's, and "Schedule K-1 (Form 1041)" is the form of the Schedule K-1 used by trusts. Most ETF's are structured as partnerships or trusts. It really makes no difference which particular flavor of Schedule K-1 your receive; the important thing to understand is that all these entities are known as "pass-through" entities, meaning that they generally do not pay income taxes. Instead, their economic activities are "passed through" to the partners/shareholders/beneficiaries so that they can include this activity on their own income tax returns. The "pass through" of economic activity is independent of actual cash distributions.

Simple example:

Partnership of 10 partners with equal ownership reports business income of $10,000 and distributes no cash to the partners. The result of this is that each partner reports business income of $1,000 on their own income tax returns, even though they've received no cash.

Generally speaking, simple distributions of cash reduce each partner's basis in their investment in the partnership and reduce their partnership capital accounts on the books of the partnership. Until and unless the cumulative distributions exceed their basis they have no capital gains to report so until they reach that point the recording of distributions is not a taxable event.

You say "when I enter the distribution it increases my taxable income" but I wonder if you are using that term properly? Is it really the income elements off the Schedule K-1 that you are reacting to?

Tom Young

T

TomYoungAnswer

I have a feeling that you are not understanding the underlying concept of "partnerships", which I assume is the form of the ETF or whatever you bought.

"Schedule K-1 (Form 1065)" is the title of the Schedule K-1 used by partnerships, "Schedule K-1 (Form 1120S)" is the title of the Schedule K-1 used by Sub-S Corp's, and "Schedule K-1 (Form 1041)" is the form of the Schedule K-1 used by trusts. Most ETF's are structured as partnerships or trusts. It really makes no difference which particular flavor of Schedule K-1 your receive; the important thing to understand is that all these entities are known as "pass-through" entities, meaning that they generally do not pay income taxes. Instead, their economic activities are "passed through" to the partners/shareholders/beneficiaries so that they can include this activity on their own income tax returns. The "pass through" of economic activity is independent of actual cash distributions.

Simple example:

Partnership of 10 partners with equal ownership reports business income of $10,000 and distributes no cash to the partners. The result of this is that each partner reports business income of $1,000 on their own income tax returns, even though they've received no cash.

Generally speaking, simple distributions of cash reduce each partner's basis in their investment in the partnership and reduce their partnership capital accounts on the books of the partnership. Until and unless the cumulative distributions exceed their basis they have no capital gains to report so until they reach that point the recording of distributions is not a taxable event.

You say "when I enter the distribution it increases my taxable income" but I wonder if you are using that term properly? Is it really the income elements off the Schedule K-1 that you are reacting to?

Tom Young