Top Tax Myths: "K-1s are an accounting and tax department problem"

Is the K-1 a tax document or is it an informational report? This is actually quite a philosophical question. On one hand, a partnership is not completing a tax return but is actually calculating tax and distributing information and associated tax responsibilities to partners. The partnership form is Form 1065, which includes a Schedule K summarizing all the K-1 activity, the actual Schedules K-1 for each partner, the K-2, which summarizes the international activity, and the actual Schedules K-3 for each partner. If you take away look-back calculations, interest, and audit adjustments that the partnership may file on behalf of its partners, there would not even be a payment section on this return.

By statute, a partnership must provide information for the taxpayer (individual, corporate, tax-exempt, etc.) to appropriately complete their tax filings. How this is done is in three parts:

1. Like all other entities, a partnership’s tax is calculated by taking the financial statement income and applying adjustments (up or down) based on relevant tax determinations. This is getting us to the taxable income that will be distributed to the partners.
2. This is when the partnership needs to “allocate” income based on the provisions of the partnership agreement, which is a legal document. The partnership agreement dictates how income, liabilities, and assets are distributed to the partners.
3. Since a partnership does not pay a legal entity tax, the taxable income (as allocated) is communicated to the partners with enough information to prepare that partner’s tax return: individual, corporate, tax-exempt, etc.

If you look at the three steps outlined, you could conclude that the K-1 problem is really the responsibility of three separate groups: tax, legal, and communications. And if you separate the communications piece as its own issue — communicating what the tax/legal advisors provided — you could conclude that the K-1 problem is a data or information distribution problem, not a tax problem at all. Communications normally rests with investor relations and we are already seeing job postings at large funds and wealth management organizations with job titles like “Tax & Client Relations.” These companies are recognizing the commingling of these various skill sets to support communication with the partners/investors.

Tax is a very complex discipline and flow-through tax is extremely complex. However, the communication of this information could be handled in a more straightforward way if all parties took a more standardized approach.