Do I Need to File a K-1 With a Loss?

A Schedule K-1 is an informational tax document issued to individuals who hold an interest in pass-through entities, such as partners in a partnership, shareholders in an S-corporation, or beneficiaries of a trust or estate. It reports an individual’s share of the entity’s income, losses, deductions, and credits for the tax year. Its purpose is to ensure income earned by these entities is taxed at the individual owner or beneficiary level.

Understanding Your K-1

A Schedule K-1 details an individual’s portion of the financial activity from a pass-through entity, including income, gains, losses, deductions, and credits. The K-1 is an informational statement provided to the taxpayer and the Internal Revenue Service (IRS) by the entity; it is not a form the individual files with their tax return.

Different K-1 forms exist based on the issuing entity. Form 1065 Schedule K-1 is for partnerships, including multi-member Limited Liability Companies (LLCs) taxed as partnerships. Form 1120-S Schedule K-1 is for S-corporations, and Form 1041 Schedule K-1 is for beneficiaries of trusts and estates. These forms detail items like ordinary business income or loss, rental income or loss, guaranteed payments, and distributions.

General Tax Filing Requirements and the K-1

An individual’s obligation to file a federal income tax return depends on their gross income, filing status, and age. Income thresholds vary, with different requirements for single filers, married individuals filing jointly, or those age 65 or older. If a person’s gross income meets or exceeds these annually adjusted thresholds, they must file a tax return.

A Schedule K-1 does not automatically create a filing requirement. The income or loss reported on the K-1 must be combined with all other sources of an individual’s income to determine if their total gross income surpasses the IRS filing thresholds. Even if a K-1 reports zero income or a loss, other income streams might still necessitate filing a tax return. If total gross income, including K-1 amounts, remains below the threshold, a tax return may not be required, though filing might still be beneficial.

How Losses on a K-1 Affect Your Filing

Even when a Schedule K-1 reports a loss, individuals must report this loss on their tax return if they are otherwise obligated to file. The deductibility of K-1 losses is subject to several limitations imposed by tax law. These limitations prevent taxpayers from deducting losses that exceed their economic investment or participation in the activity. Any disallowed losses can be carried forward to offset income in future tax years.

One common restriction is the basis limitation, found in Internal Revenue Code Section 704. This rule limits a partner’s or S-corporation shareholder’s ability to deduct losses to their adjusted basis in the partnership interest or S-corporation stock. Adjusted basis includes capital contributions, undistributed income, and certain increases from debt, reduced by distributions and previously deducted losses. Losses exceeding this basis are suspended and carried forward indefinitely, deductible when the taxpayer’s basis increases.

Another limitation is the at-risk rule, found in Internal Revenue Code Section 465. This rule limits a taxpayer’s deductible losses to the amount they are “at risk” in the activity. The at-risk amount includes cash contributed, the adjusted basis of other property contributed, and amounts borrowed for which the taxpayer is personally liable. It excludes amounts protected against loss through nonrecourse financing. If a loss exceeds the at-risk amount, the excess is disallowed for the current year but can be carried forward and deducted in subsequent years when the at-risk amount increases.

Finally, the passive activity loss (PAL) rules under Internal Revenue Code Section 469 state that losses from passive activities can only be deducted to the extent of passive income. A passive activity is a trade or business in which the taxpayer does not materially participate, or any rental activity. Material participation involves regular, continuous, and substantial involvement in the operations of an activity. If passive losses exceed passive income, the excess is suspended and carried forward indefinitely, available to offset passive income in future years or fully deductible upon a qualifying disposition of the entire interest in the activity.

Reporting K-1 Losses on Your Tax Return

When an individual receives a Schedule K-1 reporting a loss, the information from this document is used to complete specific forms and schedules that are submitted with their Form 1040, U.S. Individual Income Tax Return. The K-1 serves as the source document for the reported figures.

Most K-1 losses from partnerships and S-corporations are reported on Schedule E (Form 1040), Supplemental Income and Loss. The ordinary business loss reported on the K-1, after applying any basis or at-risk limitations, is entered on the appropriate line of Schedule E. For beneficiaries of trusts and estates, K-1 information is reported in Part III of Schedule E.

If the K-1 loss originates from a passive activity, taxpayers must utilize Form 8582, Passive Activity Loss Limitations. This form is used to calculate the amount of passive loss that is currently deductible, considering the rules that restrict passive losses to only offset passive income. If the loss is subject to the at-risk rules and exceeds the amount the taxpayer has at risk, Form 6198, At-Risk Limitations, is used to determine the deductible portion of the loss. The determined deductible amounts from these forms then flow to Schedule E or other relevant schedules on Form 1040.