How to Complete Schedule K-1 (Form 1065) (A Step-by-Step Guide): Part 3 - Financial Education Platform (2024)

Introduction

Under Part 2, we captured some of the basic data required. This is the section of Schedule K-1 (Form 1065) that will be used to record the member’s share of the LLC or partnership’s taxable income.

Schedule K-1 (Form 1065): Part III – Partner’s Share of Current Year Income, Deductions, Credits, and Other Items

Here are the details:

• Line item 1: Ordinary business income (loss) is the member’s portion of your LLC’s trade or business income.

• Line item 2: This line item relates to passive net rental real estate income.

Only passive income must be recorded on this line. Income earned by real estate professionals who materially participated in their activities is not passive income.

Page 8 of the Schedule K-1 (Form 1065) instruction has more on what ‘passive’ income means.

If the partnership had more than one rental real estate activity, a statement identifying the income or loss from each activity must be attached.

• Line item 3: This line item is asking for the member or partner’s portion of all other forms of rental income (other than what has been captured on line item 2) received by your LLC.

Again this is another passive income or loss line, plus, if there is more than one activity a statement must be prepared and attached.

Losses require IRS Form 8582to be completed.

Form 8582 will help the member to figure out how much of the loss can be reported on Schedule E.

• Line items 4a, b & C: Guaranteed Payments must be captured on this line. What is a guaranteed payment? Guaranteed payments are payments made to the member for whom Schedule K-1 (Form 1065) is being prepared without regard to the income of your LLC.

An example here will be if your LLC pays for health insurance for the member.

Any other guaranteed payments that require the use of capital will fall under 4b.

Guaranteed payments related to services are typically not passive and must be recorded on Schedule E.

Capital-guaranteed payments are not passive income and must be recorded on Schedule E.

4c is a derived number, which is 4a plus 4b.

• Line item 5: This line item requires the member’s portion of the LLC’s interest income which is inclusive of exempt-interest dividends, which are exempted from taxes.

An example of interest income will be interest received in the savings account of your LLC, bonds, or any money market instruments, etc.

• Line item 6a, b &c: This line item will be used to record the member’s portion or share of both ordinary and equivalent dividends as well as dividend equivalents.

Dividend Income can fall into three (3) categories:

1. Qualified dividends – What is a qualified dividend? A qualified dividend is a dividend that is taxed at long-term capital gains tax rates (which are lower than the normal income tax rates). The charge ranges between 0-23.8%.

To be taxed at a qualified dividend rate, your LLC would have owned the stock of a US corporation or corporations with US ties for more than 60 days within a 121-day period that starts counting 60 days before the stock’s ex-dividend date.

If the dividend was earned from preferred stocks, the 60 days will change to 90 days.

An entity with a US tie is a foreign corporation that is incorporated in a US possession or located in a country with an income tax treaty with the United States or their stock is traded in a US securities market.

A dividend cannot be a qualified dividend if the dividend:

Φ Was paid by a tax-exempt organization,

Φ Was a payment in place of the dividend; or

Φ Was a capital gains distribution.

2. Ordinary dividend: What is an ordinary dividend? Ordinary dividends are dividends that are not qualified dividends and are hence taxed as ordinary income.

3. Dividend equivalent: What is dividend equivalent? Dividend equivalent is a type of dividend where the recipient receives the right to receive an income whether in the form of cash or stock or some other asset in place of earning a dividend that would have been based on issued shares on the record date of the dividend.

• Line item 7: All royalties received/earned by your LLC must be captured on this line.

• Line items 8 & 9a: This is used to calculate the member’s portion of both short (less than a year) and long-term (more than a year) capital gains that are distributable to members of your LLC.

Both short and long-term capital gains are calculated as follows: sales price or exchanged value of the asset/s less the base cost, which is calculated as the purchase price plus any improvement cost.

Note that long-term capital gains taxes are higher than short-term capital gains tax rates.

Schedule D must be used to record both types of capital gains.

• Line item 9b: Collectibles are items that increase in value due to popularity or rareness. A typical example will be rare stamps, antiques, etc.

Gains, which are calculated as sales price or exchanged value less base cost (purchase price plus any improvement cost) are taxed by the IRS at 28% if sold after one year.

The member’s portion of this needs to be recorded on this line.

• Line item 9c: This line item has to do with the member’s portion of the LLC or partnership’s unrecaptured Section 1250 gain.

Section 1250 properties are real properties like buildings and land that are depreciable. Leasehold lands are included as well.

The depreciation recapture under this section is fairly straightforward, in that the IRS is targeting the excess depreciation your LLC may have deducted over the years, as income.

Here is an example: Beauty Am I LLC bought salon equipment for $80 000 in 2018.

The LLC owner wanted a newer version of the same equipment so they sold the existing one for $115 000 in December 2020.

The LLC had claimed depreciation on the property of $20 000 by the time of the sale.

Here is how the unrecaptured section 1250 gain will be calculated:

1. Selling Price: $115 000.

2. Adjusted basis: Purchase price: $80 000 less the depreciation amount of $20 000 = $60 000.

3. Tax profit made: The selling price of $155 000 less the adjusted basis of $60 000 = $95 000.

4. The section 1250 gain is the difference between the Purchase price less the adjusted basis because the property was sold above the adjusted base.
   Section 1250 gain: Purchase price: $80 000 less adjusted basis: $60 000 = $20 000

5. Therefore $20 000 of the $95 000 total gain will be taxed at higher capital gains tax rate and the remaining $75 000, will be subject to long-term capital gains tax rates, which are lower.

These two amounts will be captured on both schedule D and IRS Form 8949 to possibly offset other capital losses.

Unrecaptured Section 1250 gains are generally taxed at a maximum rate of 25%.

Page D-14 of the Schedule D instruction has a statement that is to be used for computation of the Unrecaptured Section 1250 gain that should be completed and attached to your LLC’s Form 1065.

• Line item 10: This line item covers the member’s portion of Net Section 1231 gain or loss.

Net Section 1231 gain or loss covers depreciable or real property that is held for more than a year.

Not all properties qualify as section 1231 properties. An example will be patents, inventions, inventory held for resale, etc.

Section 1231 gains are taxed at the lower of ordinary income tax and the capital gains tax rate.

The tax treatment of sections 1245 and 1250 properties is determined by applying Section 1231 using IRS form 4797. It must then be reported on Schedule D as required by Form 4797.

Let’s look at an example:

Jump How High LLC bought two (2) buildings for $400 000 (Building A) and $350 000 (Building B) in 2017.

These two buildings were later sold in 2021 to an investor for $650 000 (Building A) and $300 000 (Building B), by when the accumulated depreciation on the two buildings was as follows:

Building A: $85 000 and Building B: $40 000.

Net Section 1231 will be computed as follows:

• Line item 11: Other income or losses: if there are other income or losses other than what has been captured on the Form 1065 line items, they must be included here.

• Line item 12: This line item relates to the member’s share or portion of your LLC’s Section 179 deductions: Section 179 is the IRS’s reprieve for taxpayers that enables them to deduct certain tangible property purchases as expenses in the year that they are placed in service.

We call it ‘speed depreciation’ – the expense is deducted all at once – section 179 can be a great asset to a business owner.

• Line item 13: This line item requires the capturing of the member’s portion of various other deductions. Other deductions typically consist of the following:

1. 1. Contributions – this relates to charitable contributions.Generally, no deduction is allowed for any contribution of $250 or more, unless your LLC obtains a written acknowledgment from the charitable organization that shows the amount of cash contributed, describes any property contributed, and gives an estimate of the value of any goods or services provided in return for the contribution.
      

   2. Investment interest expense – Interest expense incurred on financial obligations used to invest in the LLCs assets.

   3. Deductions as they relate to royalties received by the LLC or partnership.

   4. Section 59 (e)(2) Expenditures – Generally, the LLC makes an election to deduct the LLC’s deductible ‘qualified expenditures’ ratably over 10 years (3 years for circulation expenditures). The deduction is taken at the beginning of the tax year in which the expenditure was incurred (or for intangible drilling and development costs, over 60 months beginning with the month in which such costs were paid or incurred). The term “qualified expenditures” includes only the following types of expenditures paid or incurred during the tax year.

   5. Circulation expenditures – establish, maintain, or increase the circulation of magazines, newspapers, or other kinds of periodicals.

   6. Research and experimental expenditures.

   7. Intangible drilling and development costs.

      See Also

      IRS Form 1065 Schedule K-1 (2023) - Partner’s Share of Income, Deductions, Credits, etc.

   8. Mining exploration and development costs.

   9. Educational assistance benefits are paid on behalf of the member.

   10. Dependent care benefits are paid on behalf of the member.

   11. Pre-productive period expenses are paid by the LLC. Note that pre-productive expenses can be capitalized as well in line with Publication 225. This publication also explains how federal tax laws apply to farming.

   12. Other Deductions – Your LLC could have other deductions that need to be reflected here for the member – an example will be deductions related to royalty payments received. Any expense that was incurred in the production of income must be captured and the member’s portion must be shown.

• Line item 14: This line item represents the total income and a further split of the total income into farm and non-farm income. The member’s portion of these amounts should be entered on their schedule K-1.

• Line item 15: This line item speaks to the member’s share of credits that an LLC receives for low-income housing.

The Low Income Housing Credit Program was enacted by Congress to encourage new construction and rehabilitation of existing buildings as low-income rental housing for households with income at or below certain income levels.

This is really to incentivize private developers who may not receive enough rental income from a low-income housing project to cover the costs of development and still provide a return to investors, sufficient to attract the needed equity investment.

The program provides tax incentives for investors to make equity investments.

In exchange for equity, investors receive tax credits and other tax benefits associated with ownership of the project to offset federal income taxes for ten years.

These tax benefits, plus the possibility of cash proceeds from the eventual sale of the project, represent the investors’ return on investment.

If your LLC received any such credit, the member’s share must be entered on this line.

Also to be reflected here are the member’s portion of credits related to rental real estate and the credits that your LLC would have received which is inclusive of qualified rehabilitation expenditures.

Several other credits have been detailed in the Schedule K-1 (Form 1065) instruction that an LLC needs to reflect on this line for a member or partner if such credit applies to it.

• Line item 16: This section of Schedule K-1 (Form 1065) is used by the IRS to obtain details about the member’s portion of foreign source income, deductions, and total foreign taxes paid as well as credits that may be due to your LLC.

You can leverage the items captured on Schedule Kon your IRS Form 1065 to complete this.

• Line item 18 – This line will be used to record the member’s portion of all your LLC’s income that is exempted from a tax perspective as well as any expenses that the LLC is not allowed to deduct for tax purposes.

• Line item 19 – These line items relate to the LLC’s distributions of cash or marketable securities or any other property to LLC Members. The member’s portion of these transactions must be recorded here.

• Line item 20: This is like a catch-all box where the IRS is looking for you to capture the member’s portion of certain specific ‘other’ information.

The schedule K-1 (Form 1065) instruction formis a good source here. It covers the following, however:

Investment income; Investment expenses; Qualified rehabilitation expenditures (other than rental real estate); Basis of energy property; Recapture of low-income housing credit; Recapture of investment credit; Recapture of other credit; Look-back interest—completed long-term contracts; Look-back interest—income forecast method; Dispositions of property with section 179 deductions; Recapture of section 179 deduction; Interest expense for corporate partners; Interest due under Section 453(l)(3); Interest due under Section 453A(c); Interest due under Section 1260(b); Interest allocable to production expenditures; Capital construction fund (CCF) non-qualified withdrawals; Depletion information—oil and gas; Unrelated business taxable income.

• Line item 21: At-risk activities:In general, section 465 limits the amount of deductible losses a member or partner can claim from certain activities.

The at-risk limitations don’t apply to your LLC itself, but, it applies to each LLC member’s share of net losses that can be attributed to a business activity that generated a loss.

Note that how the IRS treats each LLC member’s share of the LLC’s losses depends on the nature of the activity that generated it, therefore the IRS is requiring the LLC to report the items of income, loss, and deduction separately for each activity.

The at-risk limitation specifically applies to individuals, estates, trusts as well as certain closely held C corporations.

At-risk rules are generally applicable to:

1. 1. Holding, producing, or distributing motion picture films or videotapes.

   2. Farming.

   3. Leasing section 1245 property, including personal property and certain other tangible property that’s depreciable or amortizable. Section 1245 properties are tangible or intangible properties that could be or are subject to deprecation or amortization respectively, according to the IRS.They exclude real estate and structural components. They however include the following:

Φ Tangible or intangible properties used in the course of business for production, extraction, manufacturing, communication, furnishing, electrical power, gas, water, sewage, or even disposal services.

Φ Any facility used for large mass or bulk storage or as a research facility for the afore-described activities can also be a 1245 property.

Φ Exploring for or exploiting, oil and gas.

Φ Exploring for, or exploiting, geothermal deposits (for wells started after September 1978).

Φ Any other activity not included in the above, but is carried on as a trade or business or for the production of income.

• Line item 22: Passive activity –Section 469 deals with passive activities. It generally includes:

1. 1. Activities that involve the conduct of a trade or business, if an LLC member doesn’t materially participate in the activity, and

   2. All rental activities regardless of a member or partner’s participation, except when carried out by a real estate professional who materially participates in it.

In general, section 469 limits the amount of losses, deductions, and credits that partners can claim from “passive activities.”

The passive activity limitations don’t apply to the LLC, but, to each LLC member’s share of any income or loss and credit attributable to a passive activity.

Since the treatment of each LLC member’s share of LLC income or loss and credit depends on the nature of the activity that generated it, the LLC must report income or loss and credits separately for each activity.

If the partnership had more than one activity, it must report information for each activity on an attached statement to Schedules K and K-1. There are a few exceptions:

If your LLC has ‘at risk activities’ or ‘passive activities’, the respective boxes must be checked.

Conclusion

We have provided the above to help entrepreneurs to see the amount of detail required to complete IRS Form Schedule K-1 (Form 1065).

A great deal of detail is required. As with all tax forms, the last thing you want is to provide statements or numbers to a member that has been misstated.Any misstatement on Schedule K-1 could lead to errors or misstatements on your members’ IRS Forms 1040, Schedule SE, Schedule D, Schedule E, etc.

Which could lead to IRS audits, interest charges, or even penalties, if it further leads to late tax payments.

This is why it is worth repeating what we stated above:We strongly advise the use of a Tax Accountant or Certified Professional Accountant, who are experts at putting tax returns together.

It is always best to be able to speak to a human being about your tax affairs even if you end up filing it yourself.

This will help you know how complex your tax affairs are, which will enable you to put the right controls in place to manage the risk.This is especially true if your LLC has major assets, distributes assets, or is involved in foreign transactions.

If that option is not viable for your LLC, good tax software takes out the human error element from taxes.

The benefits you can realize will far exceed the cost in the end.After obtaining some good knowledge from this page, one should be able to follow through with a tax software medium of filing with ease.

It saves a whole lot of time and ‘hassle’ to get your taxes right the first time, and it can be done.

Source

**Please note that the above does not constitute advice in any shape or form. Please consult an accountant or an attorney for all business or tax advice.