How do I fill out Form 1065 and Schedule K-1 for a partnership?

Do your tax clients include partnerships? CPAs working with a partnership should know all about Form 1065 and Schedule K-1. Inside, you will learn about financial information, liability types and passive activity.

Information Return

The Form 1065 is only six pages long. The information for it comes from the income statement and balance sheet. It is an information return, not one for which taxes are due (as opposed to Form 1040). Form 1065 is where you report the partnership’s operating results. You report income, deductions, credits, gains and losses.

A partnership is two or more owners combining money, labor, property or skills and splitting the profits (and losses) at the end. Common kinds of partnerships are general, limited and LLPs. If your client operates a general partnership, then the partners are all personally liable for any debt the partnership incurs. If the business is a limited partnership, then some partners’ liability can be capped.

The due date for Form 1065 is the 15th day of the third month following the tax year end. So if the partnership runs on a calendar-year basis, then the due date is March 15. There’s a 6 month extension available.

Schedule K-1 Reports the Income, Loss, Credits, Deductions

The Schedule K-1 is part of Form 1065. Schedule K-1 reports the income, loss, credits, deductions, etc., received by each owner of the partnership or S corp, estate or trust. The owner must report the information on their personal tax return.

K-1 Part I reports general information about a partnership, such as its name, address and IRS service center. It’s automatically filled in from the return.

K-1 Part II is all about the partner. It asks for his/her name and taxpayer ID number. It also asks for more:

• The partner type: general or limited? Is the partner foreign or domestic?
• This section asks for each partner’s percentage interest in profit, loss and capital for both the beginning and end of the year.
• The next box asks for the partner’s share of the partnership’s liabilities.

Make sure to ask your client for a copy of the partnership agreement. The agreement holds the Part II information. If you have an already confirmed Excel spreadsheet, import the partner data from it. This saves time, because you do not have to retype the information already in the spreadsheet.

What kind of liability does each partner have? Make sure you know that before preparing the Form 1065.

One type of debt is recourse debt. Recourse debt is a secured loan, with the lender retaining the right to take collateral plus the borrower’s other assets if he fails to repay the debt. Recourse loans are lower risk for lenders.

A second kind of debt is nonrecourse. In a nonrecourse debt, the borrower’s liability is limited to the collateral (AKA the property that the loan was secured by). When the borrower defaults on a nonrecourse loan, the lender gets the collateral and cannot pursue the borrower’s assets.

Qualified nonrecourse debt is debt that no one is personally liable to repay. It’s used in holding real property and is either government-lent or guaranteed, or from a qualified person. In a qualified nonrecourse loan, both lender and borrower are qualified people. A qualified person is someone legally able to make a contract. This type of loan allows a qualified person to avoid personal liability for partnership debt.

Both recourse and qualified nonrecourse debt raise the at-risk basis. The at-risk basis determines each partner’s deductible losses. You should understand the differences between these three types of debt because the amount of deductible losses each partner can claim depends on their type. Be sure to show liabilities accurately on Schedule K-1.

Not only must you determine each partner’s share of income and loss, but also if the activity is passive or nonpassive.

Passive activity is when a partner is in a trade or business and doesn’t materially participate in it. Passive activity losses can only be offset by other passive income.

Nonpassive activity is the opposite of passive activity. If a partner materially participates in the trade or business, then that activity is nonpassive. Several tests decide this. Nonpassive losses are much easier for a taxpayer to use.

Box L summarizes the partner’s capital account activity for the year. It shows contributions, net income (loss), withdrawals and distributions. After completing Schedule K-1, ensure that each partner’s total ending capital amount matches the rest of the return. If it doesn’t, you’ll need to double check the figures. Most tax software programs will send a diagnostic warning if the figures don’t balance.

Boxes M and N deal with built-in gain and Section 704(c). If a partner contributes property to a partnership instead of cash, boxes M and N come into play. Built-in gain is the fair market value of a property over its tax basis on the date of contribution. When one partner contributes property to a partnership whose FMV differs from the basis, partners can’t shift the tax items. This is known as Section 704(c).

Part III shows the partner’s yearly share of income, deductions, and credits. This information mainly comes from Schedule K on page 5 of the Form 1065. This section of Schedule K-1 is pretty self-explanatory, and mostly covers interest, ordinary and qualified dividends, royalties, short and long-term capital gains, Section 179. Other entries include self-employment earnings, AMT items, rental income, distributions, tax-exempt income, foreign taxes paid, etc.

List each type of income separately. Separate guaranteed payments, ordinary business income, unrecaptured Sec. 1250 gain and other income. Ordinary business income comes from the partnership’s operations. It’s the net profit or loss of a business. It’s the total revenue from all sources minus the business expenses.

Guaranteed payments are usually for the partners’ time or capital. These payments may be subject to self-employment tax. If a partnership has partners who aren’t limited, then those partners may owe self-employment tax on the portion of ordinary business income allocated to them.

Box 16 was new for 2021. Box 16 indicates Schedule K-3 is attached for purposes of reporting international items. Schedule K-3 helps partners determine U.S. income tax.

Box 20: Other information. Often, that means practitioner footnotes. This is an important box to look at. The footnotes tell the partners where to report the information. There are a lot of footnotes and codes, covering credits, income and expense items to report on the partners’ own returns. Often, they report details on a Section 199A qualified business income deduction. Partners will need that info to complete their tax return. Also, see if the footnotes split the municipal income into different states. This information helps partners accurately report the numbers on their returns.

Getting the Classifications Correct

The Schedule K-1 may look straightforward, but even experienced tax pros may stumble. Its most important element is getting the classifications correct.

There are three things you must get right: partner types, income types, and debt types.

Watch out for misclassification. It can do a lot of damage to the client’s position and to your business relationship. Hedge, private equity and real estate funds are increasingly popular. Give the Form 1065 your careful attention.