Top Tax Myths: "Investors Want K1 Packets To Mirror What Was Sent Last Year."

This is a very dated notion. In the days of old, when K-1 packages were delivered in the mail, tax professionals likened the Schedule K-1 to that of an annual report. Firms took great pride in creating their “proprietary” K-1s that had a professional look and feel detailed information and were executed consistently across the firm. But this simply no longer applies.

Today, however, K-1s are distributed through and downloaded from web portals. And for reasons we will get into in Myth #4, data is pulled and aggregated by teams of people, and sometimes, even bots. The goal of collecting this information from investors is to quickly gather the data, extract what is needed and add it to other K-1 data so that the investor’s tax liability and filing responsibilities can be ascertained.

In addition, most K-1 packets are delivered to partners and investors piecemeal. For example,  first, an estimated K-1 is received, then the federal data, then the state and local information, and lastly, the international data and Schedule K-3. Sometimes, investors receive corrected or amended federal data before they have received the last pieces of state and international information. Given the late delivery of the K-1 package, the staffing shortage, and the overall complexity of the process, K-1s are downloaded and immediately scanned, marked up, and moved to the next stage. No one is taking time to revel in the beauty of that packaged K-1.

Furthermore, when we asked large institutional investors whether it is more important to follow the prior year’s format for a particular K-1 or mirror formats of a common standard, they unilaterally indicated that following a standard format would be far more important. Do you remember getting guidance in high school that your papers should follow the KISS (Keep it Simple, Stupid) Principle? The KISS Principle is based on two theories:

1. People want to use things that are simple
2. Simplicity is an advantage because it helps people complete tasks faster, easier, and in a less expensive way.

Let’s put that into the context of a K-1.

People will be interested in a K-1 that gives them the information they need in a structure that they can understand, and with access to data they can seamlessly tap into their systems.

Tax is very complicated. Plus, making tax determinations and allocating those tax attributes amongst the partners is a complex process — especially as reporting requirements continue to grow. Complexity is compounded when the recipients of a K-1 packet are looking for different details based on their legal entity. But we can simplify the overall presentation of these items if we think about the footnotes as a story with a beginning, middle, and end.

The Beginning: Laying out the details

• Federal and Overflow statements – this is the Lines 1-20 of the Schedule K-1 form and the approximately 200 “overflow” items that are itemized in the instructions.
• State K-1s, State Apportionment, and Other State Data
• International activities and ownership

The Middle: Interpreting how these details affect the investor’s tax responsibilities:

• Federal – Within the federal statements there will be additional information provided relative to those disclosures affecting taxation at the taxable entity level. These are taxable items like interest, dividends, unrelated business income, passive activity, etc.
• State – Depending on the investor’s legal entity type, different information is required. For example, a corporate entity will want the state apportionment schedule to combine with its other factors. Meanwhile, a tax-exempt entity will want a breakdown of unrelated business income by state. And individuals may not do much with state information beyond determining credits for taxes paid to other states.
• International – Like federal and state, there may be nuances from the information reported that will vary based on the investor’s legal entity type.

The End: How the collective information from all K-1s creates the tax picture for a legal entity.

This is why a consistent format is so important. As individual K-1s are analyzed, it is important to aggregate this information across the entire portfolio of K-1s since this aggregated data is what is establishing the tax liability and filing responsibilities.

Following a straightforward, consistent format is the first step toward the next generation of K-1 reporting.