How to Report K-1 Income on a 1040 Tax Return

Taxpayers who receive a Schedule K-1 must report income, deductions, and credits from partnerships, S corporations, or trusts on their personal tax returns. Unlike a W-2 or 1099, which reports straightforward earnings, a K-1 includes multiple types of income, each taxed differently, making it more complex to handle.

Understanding how to correctly transfer this information onto Form 1040 is essential to avoid errors, audits, or missed deductions.

Types of Income from K-1

Schedule K-1 reports various types of income, each with distinct tax treatment. Since these earnings come from partnerships, S corporations, or trusts, they follow different tax rules than wages or self-employment income. Properly categorizing and reporting each type ensures accuracy.

Ordinary Business Income

This represents a taxpayer’s share of a partnership’s or S corporation’s operational profits. For partnerships, this income is generally subject to self-employment tax if the taxpayer is actively involved. The self-employment tax rate for 2023 is 15.3%, which includes 12.4% for Social Security (up to the wage base limit of $160,200) and 2.9% for Medicare. An additional 0.9% Medicare surtax applies to self-employment earnings exceeding $200,000 for single filers or $250,000 for married couples filing jointly.

For S corporation shareholders, ordinary business income is not subject to self-employment tax. However, shareholders who actively participate in the business must take reasonable compensation as W-2 wages before receiving additional distributions. The IRS scrutinizes cases where shareholders minimize wages to avoid payroll taxes.

Dividends

If a partnership or S corporation earns dividend income, it is distributed to owners based on their ownership percentage. These dividends are classified as either ordinary or qualified, each with different tax rates.

Ordinary dividends are taxed at the recipient’s regular income tax rate, which ranges from 10% to 37% in 2023. Qualified dividends, which meet IRS holding period requirements, are taxed at long-term capital gains rates of 0%, 15%, or 20%, depending on taxable income. For example, a single filer with taxable income below $44,625 pays no tax on qualified dividends, while those earning between $44,626 and $492,300 are taxed at 15%. Income above this threshold is taxed at 20%.

Dividend income on a K-1 appears in Box 6a (total ordinary dividends) and Box 6b (qualified dividends). These amounts must be correctly transferred to Form 1040 for proper tax treatment.

Interest

Interest income on a K-1 comes from investments in bonds, loans, or other interest-bearing assets held by the entity. Unlike business income, interest is not subject to self-employment tax and is taxed at the recipient’s regular income tax rate.

Municipal bond interest, which may appear on a K-1, is generally tax-exempt at the federal level and may also be exempt from state taxes if issued in the taxpayer’s home state. However, private activity bond interest could be subject to the Alternative Minimum Tax (AMT). In 2023, AMT exemption thresholds are $81,300 for single filers and $126,500 for married couples filing jointly.

Interest income from a K-1 must be reported on Schedule B of Form 1040 if total interest and dividend income exceeds $1,500. Foreign interest income may require additional reporting, such as Form 8938 or the Foreign Bank and Financial Accounts Report (FBAR).

Capital Gains

When a partnership, S corporation, or trust sells an asset for more than its purchase price, the resulting gain is passed through to owners based on their ownership percentage. These gains are categorized as short-term or long-term, depending on how long the asset was held before being sold.

Short-term capital gains, from assets held for one year or less, are taxed at the taxpayer’s ordinary income tax rate, up to 37%. Long-term capital gains, from assets held for more than a year, are taxed at preferential rates of 0%, 15%, or 20%, depending on taxable income. For example, a married couple filing jointly with taxable income below $89,250 pays no tax on long-term capital gains, while those earning between $89,251 and $553,850 are taxed at 15%.

Capital gains reported on a K-1 appear in Box 9a (net long-term gain) and Box 9b (unrecaptured Section 1250 gain). The latter applies to real estate sales where depreciation was previously claimed and is taxed at a maximum rate of 25%. These amounts must be reported on Schedule D of Form 1040.

Passive vs. Active K-1 Income

The IRS classifies K-1 income as either passive or active, affecting taxation and loss deductions. Material participation determines whether income is considered active. The IRS has seven tests to assess this, including spending more than 500 hours on the business in a year or performing substantially all the work.

Passive income comes from activities where the taxpayer does not materially participate, such as limited partnership interests. Losses from passive activities can only offset passive income, not wages or other earnings. Excess passive losses carry forward until enough passive income is available to absorb them.

The Net Investment Income Tax (NIIT) applies to passive income for individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly). This additional 3.8% tax does not apply to active income.

Reporting K-1 Figures on the 1040

Each type of income, deduction, and credit from a K-1 must be reported in the correct section of Form 1040. Misreporting can lead to IRS notices or missed tax benefits.

Box 1 through Box 20 of Schedule K-1 contain various items that impact a taxpayer’s return. Some figures are reported directly on Form 1040, while others require additional schedules. For example, tax-exempt income from municipal bonds in Box 18 is reported on Line 2a of Form 1040, even though it does not contribute to taxable income. AMT adjustments in Box 17 may require completing Form 6251.

Deductions and credits passed through on a K-1 also affect tax liability. Section 179 deductions in Box 12 allow immediate expensing of certain business assets but are subject to income limitations. General business credits in Box 15 may require filing Form 3800.

K-1 information also impacts tax basis calculations. A taxpayer’s basis in a partnership or S corporation determines how much loss can be deducted and whether distributions are taxable. If distributions exceed basis, the excess is taxed as a capital gain. Taxpayers must track basis separately, as the IRS does not calculate it. S corporation shareholders must file Form 7203 to report stock and loan basis.

Adjustments for Losses or Deductions

Losses and deductions from a K-1 are subject to multiple limitations before they can offset taxable income. The at-risk rules limit deductible losses to the amount a taxpayer has at risk in the business, including cash contributions and personally liable loans. Nonrecourse debt generally cannot be deducted unless it qualifies under real estate financing exceptions.

Even if losses pass the at-risk test, passive activity loss (PAL) rules may further restrict their deductibility. Passive losses can only offset passive income, with excess losses carried forward. Real estate professionals meeting the material participation criteria may deduct rental real estate losses against other income if they meet the 750-hour and more-than-50% tests.

The excess business loss (EBL) limitation caps deductible losses from pass-through entities at $289,000 for single filers and $578,000 for joint filers in 2023. Losses exceeding these amounts are reclassified as net operating losses (NOLs) and carried forward.

Retaining Supporting Schedules and Documents

Proper documentation for K-1 income is necessary for substantiating tax positions and ensuring compliance with IRS requirements. The IRS can audit K-1-related items years after filing, making recordkeeping essential.

Supporting schedules, such as depreciation reports, loan agreements, and capital account statements, provide evidence for deductions and basis calculations. Partnerships should retain Form 1065 Schedule L (Balance Sheet) and Schedule M-2 (Partners’ Capital Accounts). S corporation shareholders should keep Form 7203 to document stock and loan basis.

The IRS generally requires taxpayers to retain records for at least three years from the filing date, but longer retention may be necessary. If a taxpayer claims a loss carryforward, documentation must be kept until the loss is fully utilized. For basis tracking, records should be maintained indefinitely. Digital storage solutions can help organize these documents for future reference.