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Common Misconceptions About Schedule K-1s

min read

By: Levi Waschmann, Tax Advisor at Compound

It’s tax season and all your ducks are in a row. You’re ready to file. You and your accountant wrangle some final documents, crunch some last-minute numbers, and it’s all looking good…

Until you realize you’re missing a couple of K-1s.

As a quick refresher, a K-1 is a tax form you’ll get if you invest in a partnership or any pass-through entity that files Form 1065, 1041 or 1120S. Most investors, from part-time angel investors to hedge fund managers, receive K-1s. Your K-1 reports your investment’s pro-rata portion of interest, dividends, capital gains, deductions, passive income, rental income, and more — it’s a summary of your allocated share of income and deduction items.

I’ve reviewed and entered thousands of K-1s over my career and worked with plenty of clients who held misconceptions about the form. This short essay is designed to help you cover your bases; to correct the common misconceptions about K-1s.

Misconception #1: You don’t need to wait for blank K-1s

It’s quite common to delay filing to await a single K-1. And, in these cases, taxpayers usually indicate something along the lines of “I know it’s going to be blank, so why can’t I just file now?”

Truth is, you need all your K-1s before you can file — any accountant or financial advisor who tells you differently is likely breaching their fiduciary duty. It doesn’t matter whether or not you think your K-1s will be blank or whether or not you think you’ll be getting a distribution. As a rule, you need all of your K-1s to file.

A while back, a client of mine was waiting on a K-1 so they could file their taxes. It was taking a while. So they emailed the partnership, who told them their K-1 would be blank. A few weeks later, they received a K-1 from the partnership showing $40k in capital gains. 

Lesson learned? There is no way to know if a K-1 is going to be blank until you receive the finalized version. So, before you file, you need all of your K-1s. (The only edge case is if the partnership sending you the K-1 is taking so long that you won’t be able to file taxes by the final extension date. In this case, you’d get an estimate and file an additional Form 8082.)

One final point: If a partnership you invest in does business in foreign countries, you may have a required foreign filing. Failure to report the applicable filing may result in a penalty of at minimum $10,000 per instance. 

Misconception #2: No distributions = no taxes

One misconception I see a lot is people think that:

  • If they didn’t get a distribution from the fund, they won’t pay taxes, AND
  • If they did get a distribution from the fund, they have to pay taxes 

Neither of these are generally true. Here’s why:

Imagine you invested $100k in a partnership. You didn’t get a distribution this year. But, the partnership used your capital to generate income such as interest, dividends, or capital gains. That means you have to pick up your pro-rata share of the taxes on that income, regardless of whether or not you got a distribution. Your pro-rata share of income and deductions will increase or decrease your partnership basis which will determine if future distributions are taxable or not. 

Now imagine next year you get a $10k distribution. One misconception is that you’d be taxed on that $10k — you wouldn’t be. It simply reduces your basis in the partnership from $100k to $90k. You may pay taxes on other things, but if it broke down like this, you wouldn’t pay taxes on the $10k. You would pay taxes if the distribution you get is in excess of your basis in the partnership. In the same scenario above. If your distribution was $110k, the excess $10k above your total partnership basis would be a taxable event.

Misconception #3: Dealing with K-1s isn’t expensive 

K-1s probably aren’t the first thing you’re thinking about when you’re making investments. But it’s worth keeping in mind that, if you go and invest in forty different funds, You're potentially increasing the number of documents needed to complete your return which may also increase the amount of cost it takes your accountant to prepare your return.

Blank K-1s take just a few minutes to prepare, but more complex ones can take time — the longest a K-1 has ever taken me was somewhere upwards of four hours, start-to-finish. And accountants usually are not cheap. 

If you’re thinking about investing (or do some already), you should know that the complexity of investing in dozens of AngelList funds is significantly higher than giving that same money to a VC or a hedge fund. If you invested in 50 AngelList funds and someone else invested in one hedge fund, you’d receive 50 K-1s and the other person would receive just one. This added complexity applies to both a) your taxes and b) the administrative time to either you or your advisor to track down all your K-1s. This isn’t advice of any kind, but it’s useful to have all the context as you make investment decisions.

Summary: The truth about K-1s

If you only read one thing, let it be this:

  • You need to wait for all your K-1s before filing, even if you think they’ll be blank. There’s no way to definitively know what’s on a K-1 until you get it, and filing prematurely is never a good idea — unless you have hit the extension deadline and need to get an estimate.
  • Distributions (or the lack thereof) don’t determine whether or not you have reportable income or pay taxes. You’ll pay taxes based on what the partnership is doing with your money, regardless of whether or not you received a distribution. 
  • There are added administrative costs to having lots of K-1s. Keep in mind, as you invest, that the more K-1s you have, the more labor required on the part of your accountant — and the more you’ll have to spend.

If you'd like help with your K-1s — and all your other finance and tax questions — you may want to chat with us. Compound helps people in tech (at companies like Stripe, Discord, and OpenAI) navigate complex financial situations, so they don’t have to worry about their finances. Head here to learn more about Compound.

Compound Financial Inc. (“Compound Financial”) offers software-based financial management and planning tools. Investment advisory services are provided by Compound Advisors, Inc. (“Compound Advisers”), an SEC-registered investment adviser. Compound Tax, LLC (“Compound Tax”) provides tax consulting and compliance services. Compound Advisers and Compound Tax are wholly owned subsidiaries of Compound Financial. Altogether, we refer to our business as (“Compound”). Registration as an investment adviser does not imply any level of skill or training. Nothing on this document should be considered an offer, solicitation of an offer, or advice to buy or sell securities. Compound is not a licensed lender, law firm or insurance agency, and any such services mentioned in this document are provided by non-affiliated referrers. Account holdings are for illustrative purposes only and are not investment recommendations. The content on this document is for informational purposes only and does not constitute a comprehensive description of Compound’s investment advisory services. Refer to Compound’s Brochure (Form ADV Part 2A) and Client Relationship Summary (Form CRS) for more information. Access to alternative investment deals is available for accredited investors or qualified purchasers only.