It's officially K1 season. 📅 A time of year filled with anticipation, surprise, and regret - not unlike my wedding night (badum tss) 👰.

But it's also the time of year that many novice investors 👶 in private companies and real estate deals start asking questions about their K1s - one of the main deliverables 🫴 they receive from what may be a significant investment they made.

So today, we're going in on the most common questions I get from LPs:

1. Why does the Capital Account Reconciliation look so low compared to what I contributed?
2. How did my loss get calculated?
3. How is my partnership ownership % calculated?
4. I didn't get any distributions - why am I being allocated income?
5. I got distributions but it was return of capital - why am I being allocated income?
6. Why does the guaranteed payment box have amounts in it?
7. What's in box 13?
8. What are all these different "activities"?

​

What is a K1?

But before we get to the questions, let's talk about what a K1 even is.

The best way to explain a K1 is that it's like a W2 for investors or owners in either a Partnership or S-Corp. 🤝 Like a W2 reports to the employee how much in wages they were paid, how much in taxes were withheld, and other information, a K1 reports to the partner (or S-Corp shareholder) how much income they were allocated, distributions made, and other important information.

And just like a copy of your W2 is sent to the IRS, the same goes for K1s - so don't think just ignoring it will fix the problem.

This post will focus mainly on partnership K1s - as they are far more informative and more frequent for investors and LPs. If you're a limited investor in a S-Corp you have way more problems than understanding your K1. 😥

But enough of that - let's jump in.

​

Common Questions

1) Why does the Capital Account Reconciliation look so low compared to what I contributed?

Near the bottom of the left hand side of the K1 is a capital account analysis that looks like this:

Many investors look at this calculation and are expecting to see it equal the "value" of their investment. 🔍 Meaning, if I invested $100,000 into a real estate deal and that property has appreciated, I will wonder why my ending capital account has only gone down every year. I may even accuse the CPA of preparing the return incorrectly and email him with my cousin who is a doctor and "invests in a million of these" on copy to set him straight. I digress. 🫨

But this amount is not meant to equate to fair value. 🙅 This is tracking capital - which is more equivalent to "book" or "cost" basis with some tax adjustments. The most simple capital account analyses will be: increase for cash contributed, decrease for cash distributed, and increase or decrease for income or loss allocated to that partner.

There is no adjustment in this section for fair value appreciation - unless there is a step-up in basis event which we won't get into here.

So if you, as an investor, are trying to measure how the ending capital account agrees back to what you contributed, you'd need to adjust for income or loss allocated to you and the amount of distributions received over the years. 😮‍💨

This ending capital account is important because you wouldn't normally expect to see it as a negative number - except in rare cases. But let's carry on.

​

2) How did my loss get calculated?

Man this is such a good question. Allocating losses is one of the trickiest parts of preparing K1s for partnerships because you are following two ✌️ main inputs:

1. The Operating Agreement, and
2. The Tax Rules on Losses in Partnerships

Without full knowledge of both, it is easy to get this wrong. So let's cover these at high levels.

The Operating Agreement will usually include one of two types of allocation language. (If you want to check out a previous post about OA language, click here.) The options are (a) Safe Harbor, or (b) Target Capital.

Safe Harbor language usually results in losses being allocated pro-rata with capital contributions across all partners. So if you put 10% of capital into the deal, you'd receive 10% of the investments. 🟰

Target Capital, on the other hand, would allocate losses between classes of capital first. So if you were a Class B capital partner and you sit behind Class A in distribution preference, you'd get the losses allocated to you first - pro rata between your Class B investors. 🍰

This difference can have massive impacts especially when accelerated depreciation is taken.

The other source of knowledge you need is the Tax Code. 📚 For example, normally you would not have losses allocated to investors in excess of their capital account balances unless the Operating Agreement permitted or there is minimum gain (see above linked post). Further, knowing which partner is guaranteeing the debt impacts how much in loss they can get allocated.

So the answer to this question is usually: (1) it's per the OA, (2) we tried to do it per the OA but the tax rules got in the way, or (3) we followed last year - which gets communicated as #2.

​

3) How is my partnership ownership % calculated?

Also on the left hand side of the K1 is this box that discloses how much of profit, loss, and capital this partner owns:

An interesting tid bit of tax trivia is that a disagreement of how much % is in these boxes is enough to file a Form 8082 Notice of Inconsistent Treatment and effectively "protest" the K1. But don't do that - it's usually never worth it and it invites the IRS into all your stuff. 😰

The percentages of profit and loss are a function of how much was actually allocated to that partner during the year. So depending on the type of allocation language, these can change from year to year. 🤷‍♂️

The capital % is, as the instructions to Form K1 state, "the portion of capital you would receive if the partnership was liquidated at the end of its tax year by by the distribution of undivided interests in the partnership's assets and liabilities. If your capital account is negative or zero, the partnership will have entered zero on this line." That means this line doesn't equal your "original" contribution percentage but rather your current percentage of how much total "book equity" your ending capital account represents. 🤏

Confusing? Yes. Necessary? Not really. Can I file a return without that information? Nope.

​

4) I didn't get any distributions - why am I being allocated income?

Welcome to the wonderful world of accrual - kinda.

K1s work more like accrual than cash accounting. Meaning, it is not uncommon to receive allocations of income without receiving equivalent amounts of cash distributions. This happens when increases in assets of the partnership are not always in the form of distributed cash. 😕

For example, let's say a business makes a tax profit during the year but has a large loan to the bank. The amount of payments of principal on the loan are not deductible from income but make there less cash available for distribution. 🏦

This works the same in years when a property is sold on the rental real estate side. You may sell an asset on 12/31 of a year and be taxed on that income even though the sponsor is holding back the proceeds from final distribution well into the next year. You're taxed in the year the K1 reports the income - not the year you receive the distribution. 🗓️

​

5) I got distributions but it was return of capital - why am I being allocated income?

Confusion on the source of distributions is another common issue. Many times a partnership will have "return of capital" listed as the first type of distributions made to investors. But when the business produces taxable income, that income must be allocated to those same partners.

So we will often hear that distributions were returns of capital, not profit distributions - and that's fine. But the K1 still has to show the income allocated to the partners in accordance with the OA language and terminology. You can call the distribution magical moon rocks but it doesn't change that the partner still receives income allocated to them. 🌝

​

6) Why does the guaranteed payment box have amounts in it?

Check out this box on the K1 you receive for this question:

As a partner in a partnership, you do not receive a W2 as an employee or 1099-INT for interest paid to you for capital contributions you've made. Rather, those payments are recorded as guaranteed payments on these boxes on the K1. 👆

Further, if the partner is receiving preferred returns on their capital regardless of income of the partnership, those are likely also guaranteed payments. The amounts in these boxes are taxable as income to the receiving partner and deductible to the partnership in accordance with other deductions.

These payments do not reduce capital as they effectively are a special allocation of income with an offsetting distribution.

​

7) What's in box 13?

Hahahahahahhaha - no telling:

Box 13 is a bit of a catch-all for "other deductions" that are required to be presented separately. These can be charitable donations, unique types of interest expense, types of dependent care benefits received, special types of basis adjustments, etc. 😔

If you want a breakdown of what all is in this box, you need to skim down to the footnotes to your K1 and it will give you a detailed list of what's in here. Note that these represent your allocations of these items from the partnership level.

​

8) What are all these different "activities"?

A partnership that owns several businesses or rental properties is required to break-out each of those businesses or properties for purposes of investor reporting. Unless an election is made, an investor needs to demonstrate participation in each one of the underlying activities to use any losses to offset other "non-passive" activities' income. 🧮

If this is the case, you'll see an analysis of each line of the K1 in a supplemental schedule a few pages after the main K1 that details which "activity" is generating how much of each line in the main K1. This is important information for your tax preparer - especially when some of these activities get disposed of and passive losses get released. 🕊️

​

That's a lot to digest. And those are just the most intelligent ones we get. Save this for when you get your K1 or get questions from your LPs and want to cut out the CPA from the emails.

🫡

🔔 Reminder that I offer one-off paid consultations. Reply to this email to set up a call. 🔔

​

🚨🚨Have a Question - send a reply directly to this email and I'll answer it in upcoming emails 🚨🚨

Have an idea for a newsletter? Would love to hear from you. Want a deeper dive on anything above? Let me know!

Want to read previous issues? Click here.​

If you enjoyed this, please forward on to a friend and let me know on X / Twitter.