How to Report Debt-Financed Distributions From a K-1

Debt-financed distributions from pass-through entities like partnerships and S-corporations require accurate tax reporting. These distributions occur when an entity borrows money and then distributes those borrowed funds to its partners or shareholders. Understanding their tax impact and how to report them on your individual tax return is important for compliance. This guide clarifies the process using information from your Schedule K-1.

Understanding Debt-Financed Distributions

Debt-financed distributions arise when a partnership or S-corporation obtains a loan and subsequently distributes those borrowed funds to its owners. This differs from distributions made from accumulated profits or equity, as the source of the funds is external debt rather than internal earnings. This practice can offer liquidity to owners without waiting for the entity to generate sufficient profits.

The tax treatment of these distributions is connected to the concept of “basis.” A partner’s or shareholder’s basis represents their investment in the entity for tax purposes. For partnerships, a partner’s basis includes their capital contributions and their share of the partnership’s liabilities. When a partnership incurs new debt, a partner’s basis generally increases by their share of that debt.

For S-corporations, a shareholder’s basis primarily includes their capital contributions and any direct loans they have made to the corporation. Unlike partnerships, S-corporation shareholders do not include corporate-level debt in their stock basis, although certain shareholder loans to the S-corporation can create debt basis. Debt-financed distributions, regardless of entity type, reduce a partner’s or shareholder’s tax basis in their ownership interest. If the distribution exceeds this basis, it can lead to taxable income.

The deductibility of interest expense associated with debt-financed distributions depends on how the recipient uses the distributed funds. If the funds are used for personal expenses, the related interest is generally not deductible. If used for investment or business activities, the interest may be deductible, subject to specific limitations. This tracing rule emphasizes understanding the ultimate use of the distributed funds.

Gathering Information from Your K-1

Your Schedule K-1 is the primary document for understanding your share of a pass-through entity’s income, deductions, credits, and distributions. Both partnership K-1s (Form 1065) and S-corporation K-1s (Form 1120-S) provide the necessary information, though the specific boxes and their interpretations differ.

For partnerships, your Schedule K-1 (Form 1065) details changes in your capital account and share of partnership liabilities. Box L on Schedule K-1 analyzes your capital account, showing changes like contributions and distributions. Increases in partnership liabilities can be found in attached statements or other sections, as these directly impact your basis. Distributions, including debt-financed ones, are typically reported in Box 19 of Schedule K-1 (Form 1065). Any attached statements or footnotes are important for understanding the nature of these distributions and any associated debt.

For S-corporations, your Schedule K-1 (Form 1120-S) reports your share of corporate items. Distributions to shareholders are reported in Box 16, Code D, of Schedule K-1 (Form 1120-S). While S-corporation shareholder basis does not include corporate debt directly, distributions still reduce a shareholder’s basis. Review any statements provided with your S-corporation K-1, as these may contain additional details about the distributions or changes in the corporation’s debt that could affect your basis calculation.

Reporting Debt-Financed Distributions on Your Individual Tax Return

Reporting debt-financed distributions on your individual tax return involves calculating and adjusting your basis in the entity and determining the tax treatment of any excess distributions. Accurate basis tracking is important, as distributions reduce your basis in the partnership interest or S-corporation stock. Your basis increases with income and contributions, and decreases with losses and distributions. Maintaining detailed records of your basis from year to year is important, as this calculation is cumulative.

Distributions from a partnership or S-corporation, including debt-financed ones, are generally reported on Schedule E (Form 1040), Supplemental Income and Loss. For partnerships, the distribution amount from Box 19 of Schedule K-1 (Form 1065) is typically entered in Part II of Schedule E. For S-corporations, the distribution amount from Box 16, Code D, of Schedule K-1 (Form 1120-S) is reported in Part III of Schedule E. While these distributions reduce your basis, they are generally not taxable income themselves, provided they do not exceed your adjusted basis in the entity.

If the total distributions, including debt-financed amounts, exceed your adjusted basis in the partnership interest or S-corporation stock, the excess portion is typically treated as a capital gain. This capital gain is then reported on Schedule D (Form 1040), Capital Gains and Losses. To calculate this gain, you subtract your adjusted basis from the total distribution amount. The resulting excess is generally recognized as a capital gain, which may be short-term or long-term depending on your holding period for the ownership interest.

You may also need to file Form 8949, Sales and Other Dispositions of Capital Assets, if the excess distribution is treated as a sale or exchange of your interest. Other forms like Form 8582, Passive Activity Loss Limitations, or Form 6198, At-Risk Limitations, might indirectly be affected by the basis adjustments resulting from these distributions. These forms ensure that losses and deductions are limited to the amount you have at risk and from passive activities.