My K-1 finally showed up. Now what? Many Tax Update visitors arrive here when they ask their search engines something like “understanding K-1s” or “deducting K-1 losses on 1040.” As more business income is now reported on 1040s via K-1s than on corporation returns, these aren’t trivial questions.
It helps to understand what a K-1 does. “Pass-through” entities — partnerships, S corporations, and trusts that distribute their income to beneficiaries — generally don’t pay tax on their income. The owners pay. The tax returns of the pass-throughs gather the information the owners need to report the pass-through’s tax results properly. Because many different tax items are required to be reported differently on 1040s, the income, deductions and credits of the business have to be broken out on the K-1. That’s why there are so many boxes and so many identification codes on the K-1.
The challenge for the return preparer is to take the information off the K-1 and to report it properly on the 1040. It can get especially complicated when losses are involved.
While anything short of a full seminar will oversimplify the treatment of pass-through items, there are three main hurdles a loss deduction has to clear. They are, in order (follow the links for more detail):
You have to have basis in the pass-through to take losses. Basis starts with your investment in the entity. It includes direct loans to the entity. If you have a partnership, it includes your share of partnership third-party debt. It is increased by earnings and capital contributions and reduced by losses and distributions. If you don’t have basis, the loss is deferred until a year in which you get basis.
There is no official IRS form to track basis, but many pass-throughs track basis for their owners. Check your K-1 package to see if includes a basis schedule.
Your basis has to be “at-risk” to enable you to deduct losses. While the at-risk rules are a very complex and archaic response to 1970s-era tax shelters, the basic idea is that you have to be on the hook for your basis, especially basis attributable to borrowings, to be able to deduct losses against that basis. Special exclusions exist for “qualified non-recourse liabilities” arising from third-party real estate loans. Losses that aren’t “at-risk” are deferred until there is income or new “at-risk” basis. At risk losses are computed and tracked on Form 6198.
You can only deduct “passive losses” to the extent of your “passive” income. A loss is “passive” if you fail to “materially participate” in the business. Material participation is primarily determined by the amount of time you spend on the business activity. Real estate rental losses are automatically passive unless you are a “real estate professional.”
Passive losses are normally deductible only to the extent of passive income. The non-deductible losses carry forward until a year in which there is passive income, or until the activity is disposed of to a non-related party in a taxable transaction. You compute your passive losses allowance on Form 8582.
Even if you have income, instead of losses, be sure to use any carryforward losses you might have against it. And consider visiting a tax pro if you find the whole process perplexing.
This is another of our 2015 Filing Season Tips. There will be a new one every day here through April 15!
Russ Fox, Bozo Tax Tip #5: Ignoring California
William Perez, Opportunity to Increase Charitable Donations for 2014 under a New Tax Law. “Individuals who donate cash by April 15, 2015, to certain charities providing relief to families of slain New York City police officers can deduct those donate on their 2014 tax return.”
Robert Wood, Beware Tax Mistakes IRS Calls Willful. “Even a smidgen of fraud or intentional misstatements can land you in jail.”
Have a nice day.
I’m from the IRS, and I’m here to help! IRS Agent Causes Grief For Taxpayer’s Spouse By Being Helpful (Peter Reilly)
Leslie Book, District Court FBAR Penalty Opinion Raises Important Administrative and Constitutional Law Issues. “Taxpayers should not be forced to sue in federal court to get an explanation as to the agency’s rationale or the evidence it considered in making its decision.”
Jason Dinesen, It’s Pointless for EAs to Attack CPAs. And vice-versa.
TaxProf, The IRS Scandal, Day 698
Roger McEowen, Rough Economic Times Elevate Bankruptcy Legal Issues (ISU-CALT)
Martin Sullivan, How Much Did Jeb Bush Cut Taxes In Florida? (Tax Analysts Blog). “So was Jeb Bush a pedal-to-the-metal tax slasher in Florida?”
Renu Zaretsky, It’s Spring Break, and “Everything’s Coming Up Taxes…” (No Daffodils). The TaxVox headline roundup covers IRS budget cuts, reefer madness, and online sales taxes in Washington State today.
Career Corner. Do Any Millennials Want to Work at the IRS Non-ironically? (Caleb Newquist, Going Concern). Not very hipster.