Schedule K-1, Form 1065, for Investors in the 2020 Tax Year

Updated: Apr 1

We’ve all experienced it. It’s late March. You have trouble sleeping. Maybe you develop a stress rash. You’re outright hostile to your postal carrier knowing that they might carry a dreaded Schedule K-1 to complicate this year’s tax return. No? No one has ever experienced that? Fine, it’s a bit overdramatic, but a K-1 can be anything from a mild nuisance to a big tax headache if the wrong circumstances align. Questions and actions on your specific situation should always be deferred to your accountant or tax professional, but the goal today is to provide some education and resources, so that you’re able to ask the right questions. Here are the highlights from today’s post:

  • Many MLPs, certain ETPs, and royalty trust issue K-1s complicate tax returns, but usually provide a tax advantage.

  • K-1s arrive later in the tax season, and a tax professional will often charge an additional fee per K-1 to complete a return.

  • For K-1s received after filing your original return you may decide to: do nothing, correct your return, amend your return.

  • Tax advantages may include: avoiding double taxation, tax deferment, and income exclusions

  • Take extra care holding certain investments like MLPs in IRAs; there may be unexpected tax consequences based on UBTI typically found in Box 20, Code V.

Why Did I Receive a K-1 and What Is It?

This post specifically deals with Schedule K-1 as it relates to investments in publicly traded businesses, but for the sake of completeness here are a few categories of individuals that may receive the form.

  • Private business owners or trust beneficiaries may need Schedule K-1 to complete their personal taxes, but this category likely has an accountant involved or is at least expecting the form.

  • Receiving an inheritance typically has tax consequences, and Schedule K-1 (Form 1041) is used to report income and other information about the beneficiaries share of the trust/estate.

  • Investors that purchased ownership in businesses not organized as C-Corps may need Schedule K-1 (Form 1065) to complete their tax returns.

When investors have tax obligations that come from investments in Corporations (C-Corps), whether its dividends or capital gains, they can find tax information on a consolidated 1099 tax document provided by their brokerage. However, there are a slew of other business structures like partnerships, S-corporations, royalty trusts, that are not taxed like C-Corps and will often send investors K-1s to complete their personal tax returns.

What Should I Do With the K-1 I Received?

If you receive Schedule K-1 (Form 1065) it will look something like this:

The convenience and affordability of online brokerages and trading platforms is a huge benefit to investors, but it does allow DIY investors to unknowingly purchase ownership (often referred to as units instead of shares) of entities organized as MLPs, Trusts, etc. Even some commodity-centric ETPs (the general category that ETFs belong to) could issue K-1s, so if you receive a K-1 you weren’t expecting, don’t panic, it is a common occurrence.

Okay, I Haven’t Filed My Tax Return Yet:

If you receive an unexpected K-1 in the mail and haven’t filed your taxes, pat yourself on the back because K-1s rarely arrive earlier than late March and your procrastination has finally paid off.

It will take additional time to incorporate K-1 information into your return, but the form is designed to be incorporated by individuals without any specialized expertise. If you require assistance, most accountants and tax preparers can easily handle a K-1, but they will likely charge an additional fee for each K-1., potentially offsetting any tax benefit.

I Already Filed, Now What Do I Do With This K-1?

Whether it’s to reduce risks of fraud, get a tax refund ASAP, or simply to get the chore of filing taxes over with, many people complete their tax returns well in advance of the typical April deadline. When you receive an unexpected K-1 (potentially as late as September, yes, after your taxes are due without an extension), there’s no one size fits all course of action and specifics are best discussed with a qualified accountant. That said, it may be helpful to at least be aware of some options available to you.

In the rare circumstance that the K-1 has no impact on your tax return, you may not need to take any action. If the K-1 does have an impact, but the due date of your original return hasn’t passed yet, you may have the opportunity to correct the error. This sounds ideal, but because the correction involves filing a 2nd return to supersede the original which may create more problems than it solves. Still, it may be your best option to avoid interest and penalties, so you’ll have to make that decision on a case-by-case basis. If you don’t make the correction, the IRS may suggest corrections and ask you to either agree or dispute the discrepancies. Yet another option, if your original filing date has passed, might be to file an amended return with your corrections, although you should wait until your original return has been fully processed. Whether or not you are required to amend your return is best discussed with your tax professional. If you have amended your filing, you can check its status with the IRS.

To summarize your list of potential options:

  • Do nothing, and lookout for an IRS letter in the future

  • Correct your return, if before your original return’s due date

  • Amend your return, after the IRS processes your original return

What Business Types Issue K-1s and Why?

There are exceptions to every rule, but some common, publicly traded business structures that issue K-1s are:

  • Master Limited Partnerships (MLPs)

  • Commodity-centric ETPs; the U.S. Oil Fund (USO) is the most well-known example

  • Some Currency and Derivative ETPs; here’s a list of ETPs that likely issue K-1s.

  • Royalty Trusts typically tied to oil wells, mines, or timberland

It is worth noting that just because you invest in a category above does not mean you will receive a K-1; even some MLPs do not issue K-1s depending on the specifics of their organization. If you own shares of the same K-1 issuing company in multiple brokerage accounts, you may only receive a single K-1. A notable misconception concerns Real Estate Investment Trusts (REITs), which do not issue K-1s, despite having “trust” in the name. On the other hand, Real Estate Limited Partnerships (RELPs) which share some characteristics as REITs will likely issue a K-1.

Should I Avoid Investing in Companies That Issue K-1s?

K-1s make your tax returns more complicated and can cost extra if you hire a preparer, but many investors deem the tax advantages worthwhile. Without any mitigating strategies investment returns from share price appreciation and dividends are taxed twice, once at the corporate level, then again at the investor level. The actual tax paid is influenced by many factors such as the current corporate tax rate or whether the capital gains are classified as short or long term. This all factors into the relative benefit of owning shares in a C-Corp vs. a pass-through or other organized entity. MLPs are popular investment selections and are not taxed at the corporate level because they are organized as partnerships, not corporations. The specifics of MLPs are outside this post’s scope, but they can offer many potential tax advantages:

  • Avoid double taxation

  • Pass through losses as well as profits (yes, a loss can actually be a benefit)

  • Deferred taxation

  • Partial income exclusion based on business specifics

The exact advantage will depend on the specific MLP, and there will be differences when investing in other business structures like royalty trusts. The decision is further complicated by the existence of entities like Business Development Companies (BDCs) and REITs, which offer different tax treatment from C-Corps without issuing K-1s. For many investment decisions, tax treatment is only one consideration, so the decision to invest in companies that issue K-1s is best made on an individual basis.

IRAs and Other Tax-advantaged Account Complication, UBTI/UBIT:

As you might expect, there can be complications when tax-advantaged investments are held in a tax-advantaged account like an IRA, 401k, HSA, etc. In some cases the benefits overlap; for example, an MLP allowing tax deferment isn’t beneficial in a Traditional IRA where tax is already deferred. In other situations an MLP might generate unrelated business taxable income (UBTI), which can negate the tax advantages of an IRA. If UBTI breaks the threshold, $1,000 in 2020, it creates an unrelated business income tax (UBIT). That threshold may seem low, but that $1,000 is at the investor level, so you may have to own a considerable number of shares to hit that limit. That said, owing UBIT is likely an undesirable outcome because:

  • Tax is owed in tax-advantaged account

  • The IRA is liable for the tax, pulling tax advantaged money out, plus potential penalties

  • Trust tax rates may be higher than capital gains or ordinary income rates

UBTI has more to do with the business organization than the fact that the company issues a K-1. For example, MLPs often generate UBTI, but royalty trusts, rarely, if ever, do. Furthermore, variation in business operations may mean UBTI in one year, but not another. Look for UBTI in Box 20, Code V on your Schedule K-1, although this box may not exist for entities not capable of generating UBTI. If you do exceed the threshold, look for form 990-T; this might be the time to engage professional assistance, particularly for a tax-advantaged account.

Author: Andrew Dudar is a registered investment adviser representative at JRW Advisory Services, serving clients in Colorado and across the United States where exclusions apply.

Disclaimer: The article is written for the purpose of general education and information and should not be taken as tax advice. Please consult with a qualified accountant or tax professional before taking action or making decisions about your unique tax situation.

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