Are K-1 Distributions Really Taxed? – Avoid this Mistake + FAQs

Yes, K-1 distributions are generally taxed, but how they’re taxed depends entirely on your relationship to the entity, the type of income, and applicable laws.

According to IRS data, approximately 30 million Schedule K-1 forms report over $1.2 trillion in pass-through income annually. That’s a massive slice of taxable income affecting millions of taxpayers.

This comprehensive guide breaks down everything you need to know about how K-1 distributions are taxed for partnerships, S corporations, trusts, and more.

• What exactly a K-1 distribution is and why it usually results in a tax bill 📄 – Understand how pass-through entities work and why you pay tax (not the business) on K-1 income.

• How K-1 taxation differs for partnerships, S corps, and trusts – Learn the nuances of each entity type, including federal rules and key state tax differences.

• Key tax terms explained – Pass-through taxation, basis adjustments, active vs. passive income, self-employment tax, and other concepts that impact how your K-1 income is taxed.

• Real-world examples and a comparison table – See three common K-1 scenarios (partner, S corp shareholder, beneficiary) with numbers, plus what to avoid (common mistakes ⚠️ and IRS audit triggers).

• Advanced insights and FAQs – How K-1 income compares to W-2s and 1099s, pros and cons of K-1 income, related IRS forms (1065, 1120S, 1041), landmark court cases that shaped K-1 taxation, and answers to frequently asked questions (in plain English).

What Is a K-1 Distribution and How Is It Taxed?

A Schedule K-1 is a tax form issued by pass-through entities – businesses or trusts that do not pay income tax at the entity level. Instead, they “pass” the income, deductions, and credits through to their owners or beneficiaries, who report these items on their personal tax returns.

In simple terms, a K-1 distribution represents your share of an entity’s income (or loss) and other tax items. Here’s the key: you pay the tax on that income, not the entity.

• Why a K-1? If you’re a partner in a partnership, a shareholder in an S corporation, or a beneficiary of a trust/estate, the IRS requires the entity to send you a Schedule K-1 each year. This K-1 reports your share of the entity’s profits, losses, and other tax items. You use the K-1 info to prepare your own tax return and pay any tax due on that income. The business itself typically pays no federal income tax on those profits – that responsibility passes to you.

• Is a “K-1 distribution” actual cash or just a figure? Often, people use “K-1 distribution” to mean the cash distributed to them by the entity. However, for tax purposes, the K-1 shows taxable income (or loss) allocated to you, which may differ from actual cash you received. You are taxed on the income reported on the K-1, even if the business didn’t actually distribute all of it in cash.

• For example, if your partnership reinvests earnings instead of paying them out, you could owe tax on income you never physically got – a situation sometimes called phantom income. (On the flip side, a cash distribution itself isn’t directly taxed if it’s just paying out income that was already taxed or will be taxed via the K-1.)

• Taxed as what? K-1 income usually retains the character it had in the entity. That means if the partnership’s income was ordinary business profit, your K-1 passes through ordinary income; if the S corp had capital gains, your K-1 will report capital gains, etc.

• You’ll pay tax at the applicable rate for each type of income (ordinary rates for business income, capital gains rates for long-term gains, and so on). Bottom line: K-1 distributions are taxed – but how they’re taxed depends on the nature of the income and your situation.

Let’s break down how K-1 taxation works by entity type, since the rules can vary for partnerships, S corps, and trusts/estates.

Partnership K-1: How Partners Are Taxed

If you’re a partner in a partnership (or an LLC taxed as a partnership), the partnership itself does not pay federal income tax on its earnings. Instead, each partner is taxed on their share of the partnership’s income. The partnership files an information return (Form 1065) and provides each partner a Schedule K-1 (Form 1065) showing that partner’s allocated share.

• Taxation of income: You must report the K-1 income on your own tax return, whether or not the partnership actually distributed cash to you. As the IRS puts it, partners – not the partnership – pay taxes on partnership income. For instance, if you own 50% of a partnership that earned $100,000 profit, your K-1 will show $50,000 of ordinary business income (plus any separate items like interest, etc.). You’ll include that $50k in your taxable income. If you also received, say, a $30,000 cash distribution, that distribution itself typically isn’t separately taxed at the time (more on distributions vs. income below), unless it exceeds certain limits.

• Types of income on a partnership K-1: Box 1 of a partnership K-1 reports ordinary business income or loss. Other boxes report interest, dividends, capital gains, rental income, etc., as applicable. Each retains its character – e.g. interest income from the partnership is still interest income to you. The K-1 may also show tax credits or deductions passed through, like depreciation, Section 179 expense, or credits for things like R&D or low-income housing (if the partnership had those).

• Self-employment tax: A big consideration for partnership income is self-employment tax (Social Security and Medicare taxes). If you are a general partner or an active member in an LLC partnership, your share of the partnership’s trade or business income is usually subject to self-employment (SE) tax (15.3% combined rate, up to certain income caps). Limited partners (and certain LLC members) who are purely investors generally do not pay SE tax on their share of income (except on any guaranteed payments for services).

• The distinction can get tricky – courts have held that even if you’re labeled a limited partner, if you actively participate and perform services (like in a law firm LLP), the IRS can treat you as not truly a limited partner for SE tax purposes.

• In Renkemeyer v. Commissioner (2011), for example, a law firm’s partners tried to avoid SE tax by allocating income to a limited partnership interest, but the Tax Court ruled their earnings were subject to SE tax because they were actively providing services. 🤓 Translation: If you actively work in the partnership, expect to pay SE tax on your K-1 income, regardless of your title.

• Distributions to partners: Cash or property distributions from a partnership themselves are generally not taxable at the moment of distribution as long as you have sufficient basis in your partnership interest. Your basis is essentially your investment in the partnership (initial contribution + accumulated income – prior losses – distributions). A distribution is usually considered a return of capital.

• However, if you receive distributions that exceed your basis, the excess is taxable as a capital gain. In other words, you can withdraw up to the amount of your basis tax-free (because you’ve already been taxed on that income or contributed that capital previously), but go beyond that and you’re looking at a taxable event. We’ll dive more into basis soon, because it’s crucial for understanding K-1 taxation.

👉 Key point: With a partnership K-1, you pay federal income tax (and usually state tax) on your share of the partnership’s income each year. The character of the income (ordinary, capital, etc.) and additional taxes (like self-employment tax) depend on the nature of the business and your role.

Partnership distributions are generally not separately taxed unless they exceed your basis or represent certain untaxed gains.

S Corporation K-1: How S Corp Shareholders Are Taxed

An S corporation is another pass-through entity. Like a partnership, an S corp generally pays no federal income tax at the corporate level.

Instead, its profits (and certain other items) are passed through to shareholders via Schedule K-1 (Form 1120S). If you’re an S corp shareholder, here’s what to know:

• Taxation of income: Each shareholder reports their share of the S corporation’s income, losses, deductions, and credits on their personal return. Suppose you own 30% of an S corp that made $100,000 in taxable profit.

• You’ll get a K-1 showing $30,000 of ordinary business income (assuming no special allocations – S corp allocations are strictly pro-rata by ownership). You pay tax on that $30k at your individual rate. Even if the S corp retains some of that profit for expansion (i.e. doesn’t distribute it all), you still pay tax on your full share.

• No self-employment tax on S corp distributions: Here’s a major difference from partnerships: S corporation K-1 income is not subject to self-employment tax. As a trade-off, if you work in the S corp, you’re required to take a reasonable salary as a W-2 employee, which is subject to payroll taxes (Social Security/Medicare). But any remaining profit passed through on the K-1 is not hit with SE tax.

• This is a tax advantage of S corps – avoid the 15.3% SE tax on much of the earnings – but it comes with that reasonable compensation requirement. If an S corp owner tries to pay themselves an unreasonably low salary to maximize K-1 distributions, the IRS can reclassify distributions as wages.

• In David E. Watson, P.C. v. U.S. (2012), a CPA paid himself only $24k salary while taking $200k+ as K-1 dividends; the courts upheld the IRS recharacterizing about $91k of that as wages, since $24k was “unrealistically low.” Lesson: Don’t try to game the system – pay yourself a fair wage, then enjoy the remaining K-1 profit without extra payroll tax.

• Distributions to shareholders: Cash distributions from an S corp to you are not taxable as long as you have basis in your stock. Your basis in an S corp starts with what you paid in or contributed, and it increases with income and decreases with losses and distributions. If you take out more than your stock basis (not common unless the company had losses in prior years or you pulled out a lot of money), the excess is taxed as a capital gain.

• In general, because you’re taxed on the S corp’s income as it’s earned, you can usually take distributions of those earnings later without tax – it’s essentially withdrawing already-taxed money. (One nuance: if the S corp was previously a C corporation or has built-in gains, there could be corporate-level tax on certain earnings, but that’s beyond our scope here.)

• State corporate taxes: Federally, S corps don’t pay income tax, but be aware some states levy an entity-level tax or fee on S corporations. For example, California charges a 1.5% franchise tax on S corp net income (minimum $800) in addition to the shareholders paying personal tax on the income. Most states, however, primarily tax the S corp income at the shareholder level similar to federal (with adjustments). We’ll cover more state nuances later.

👉 In short: S corp K-1 income is taxed to the shareholder as personal income, similar to partnership K-1 income. The big difference is no self-employment tax on S corp pass-through income, but S corp owners who are active in the business must take a salary subject to payroll taxes. S corp distributions themselves aren’t taxed unless they exceed your stock basis (or involve previously untaxed earnings, which generally shouldn’t occur under S status).

Trust/Estate K-1: How Beneficiaries Are Taxed

Trusts and estates can also issue Schedule K-1s (Form 1041 K-1) to their beneficiaries. The taxation rules here differ from partnerships/S corps because trusts and estates can be taxable entities – but only if they retain income.

If a trust or estate distributes income to beneficiaries, that income is generally taxed to the beneficiaries instead (the trust/estate gets a deduction for it). Schedule K-1 is the mechanism to report that.

• Distributable Net Income (DNI): A trust or estate calculates its DNI, which is essentially the taxable income available to distribute. If it distributes income to beneficiaries (or is required to), the beneficiaries will receive a K-1 showing their share of that distributed income. As a beneficiary, you pay tax on the income shown on the K-1.

• For example, if a trust has $10,000 of interest income and it distributes all of it to you, you’ll get a K-1 for $10,000 interest income and you must report that on your 1040. The trust would then generally pay no tax (it distributed its income). If the trust instead retained the income, it would pay the tax itself and you would get no K-1 (but possibly the trust principal might later distribute, which could be tax-free return of corpus in some cases).

• Character of income: Just like other K-1s, the income retains its character. Trust K-1s break out whether the income is interest, dividends, capital gains, etc. One twist: trusts often do not distribute capital gains to beneficiaries (they might allocate gains to corpus by default), unless the trust terms or state law allow treating capital gains as distributable.

• If capital gains are retained, the trust pays tax on those (and trust tax brackets are steep – they hit the highest 37% rate at about $14,000 of income!). So high-income trusts often try to distribute income to beneficiaries in lower brackets. Check your K-1: if it shows capital gain income, that means the trust likely allocated gains to you (otherwise, you might not see them, indicating the trust paid that tax).

• Federal vs state for trusts: Most states tax trust income similarly: the beneficiary pays tax on distributed income, the trust on retained. But state rules can vary on sourcing of trust income or residency of the trust vs beneficiary. If you get a K-1 from an estate or trust, generally include it on your state return as well (with any credits for taxes paid by the trust, if applicable).

• Estates (for deceased persons): During the administration of an estate (settling a decedent’s affairs), the estate may earn income (interest, dividends, etc. on the estate assets). If that income is passed out to heirs or beneficiaries, the estate issues a K-1 to each beneficiary for their share. Same idea as a trust – the beneficiary pays the tax. This prevents double taxation: you don’t want the estate and the beneficiary both taxed on the same income. The K-1 shifts the tax burden to the beneficiary receiving the economic benefit.

• Special note – Grantor Trusts: If you are dealing with a revocable living trust or certain grantor trusts, they do not use K-1s. Instead, all income is reported as if earned directly by the grantor (typically included on the grantor’s 1040 via attachments or just using the grantor’s SSN). K-1s are for complex trusts or estates (and certain irrevocable trusts) that are separate tax entities.

👉 Bottom line: If you receive a K-1 from a trust or estate, you are being taxed on that income – the IRS expects you to include it on your return. The trust/estate has effectively handed you the tax obligation along with the distribution.

Always check what types of income are listed (interest, dividends, etc.) so you know where to report them on your 1040 (typically Schedule B for interest/dividends, Schedule D for any distributed gains, etc., while also entering the K-1 details on Schedule E, Part III for beneficiaries).

Key Tax Laws and Rules Affecting K-1 Income (Federal & State)

K-1 taxation is governed by a web of federal tax laws, plus each state’s tax rules. Understanding the legal framework will help you see why K-1 income is taxed the way it is.

Federal Tax Law: Pass-Through Taxation and More

At the federal level, the concept of pass-through taxation for partnerships and S corps is embedded in the Internal Revenue Code:

• Pass-Through Entity (Conduit): Under IRC Section 701, partnerships are not subject to income tax; instead, partners are liable for tax on their distributive shares of income. S corporations (IRC Section 1363 and 1366) similarly pass income to shareholders. This is why the K-1 exists – it’s mandated to report each partner’s or shareholder’s share of taxable items.

• In plain language: The IRS treats the income as if it was earned directly by you, even though it came through a business. The tax law requires that allocation of income (not actual payment) triggers taxation – a principle confirmed by the U.S. Supreme Court in United States v. Basye (1973), where doctors in a partnership were taxed on income paid into a retirement fund on their behalf. The Court held you can’t avoid tax by diverting income; if it’s earned for your benefit, you’re taxable on it. This set the tone: K-1 allocations = taxable income to the recipient, regardless of whether they personally received the cash.

• Character and Rates: Federal law generally maintains that whatever the character of the income at the entity level flows through to you. So, ordinary business income from a K-1 is taxed at ordinary income rates on your 1040.

• Long-term capital gains or qualified dividends on a K-1 will usually get the favorable capital gains tax rates on your return, just as if you received a 1099-DIV. Tax-exempt income (like municipal bond interest) might be on your K-1 as well – that remains non-taxable to you but is reported for information. The law basically funnels the nature of each item through the entity to you.

• Basis and Loss Limitations: The tax code imposes several important limitations on losses from K-1s:

  • Basis Limitation: You can only deduct losses up to the amount you have at-risk or invested (your basis). If your partnership or S corp K-1 shows a loss but you have no basis (e.g., you already took lots of losses in prior years or only put in a small amount), the loss is suspended until you restore basis (like by future income or adding capital). Similarly, any distributions in excess of basis are taxable gains.

  • This basis tracking is critical – it’s a common area of confusion. For S corps, note that loan guarantees do not count as basis. You only get basis for direct loans you made to the S corp, not just cosigning a bank loan.

  • Courts have consistently held “no economic outlay, no basis” – you must be poorer in a real sense to claim an increase in basis. (So if you need more basis in your S corp to deduct a loss, you might formally lend it money rather than just guaranteeing a loan.)

  • At-Risk Rules: In addition to basis, if your investment is financed by non-recourse loans (where you’re not personally liable, common in some partnerships), you may be limited in deducting losses beyond the amount you’re “at risk” for. This mostly affects certain tax-shelter type investments.

  • Passive Activity Rules: The passive activity loss (PAL) rules often affect K-1 losses. If you are not materially participating in the business (i.e., you’re a passive investor), you generally cannot deduct losses from that activity against your other income like salary or interest. Passive losses can typically only offset passive income. They get suspended and carried forward if you don’t have passive income to use them against.

  • Example: You invest in a rental real estate partnership (passive by nature for most). It sends you a K-1 with a $10k loss. You can’t deduct that $10k against your wages unless you have other passive income (or until you sell your partnership interest, which frees up suspended losses).

  • On the flip side, if the K-1 shows passive income, you can use those suspended losses or you’ll just pay tax on the income. The IRS PAL rules are strictly enforced – they often challenge large “nonpassive” loss claims. So if you’re involved in multiple K-1 ventures, pay attention to whether each is passive or active for you.

  • Qualified Business Income (QBI) Deduction: This is a newer rule: many K-1 business incomes qualify for up to a 20% deduction (the QBI deduction). If your K-1 income is from a qualified trade or business (and you’re under certain income thresholds or within allowed types of businesses), you may deduct 20% of that income, effectively making only 80% taxable.

  • The K-1 should report information for the QBI deduction if applicable. Note that certain service businesses have limitations if income is high (specified service trades like doctors, lawyers have phase-outs). The QBI deduction doesn’t reduce self-employment or NIIT, just income tax. This is a federal tax break to ensure pass-through income wasn’t disadvantaged relative to C corp tax cuts.

• Additional Medicare Tax / Net Investment Income Tax: High earners should note:

  • If your K-1 income is from an active trade (partnership active income or S corp wages), it could push you into the additional 0.9% Medicare tax on high wages/SE income (above $200k single, $250k joint).

  • If your K-1 income is passive (or from an investment partnership where you don’t materially participate), and your adjusted gross income is high, it may be subject to the 3.8% Net Investment Income Tax (NIIT). Passive business income, rental income, interest, dividends, and capital gains from K-1s are generally included in the NIIT calculation. Active business K-1 income is exempt from NIIT. So, the passive vs nonpassive classification can also affect this 3.8% surtax for upper-income taxpayers.

In summary, federal tax law ensures K-1 income is taxed once at the individual level (avoiding double taxation of corporate profits), but it puts guardrails in place (basis, at-risk, passive loss limits) so that losses or distributions aren’t abused. It also distinguishes active vs passive to apply the appropriate employment taxes or surtaxes.

State Tax Nuances: How K-1 Income is Handled by States

Most states with an income tax will also tax your K-1 pass-through income, largely following the federal treatment. However, there are some important nuances and differences in state taxation of K-1 distributions:

• Resident vs. Nonresident Taxation: If you are a resident of a state, that state typically taxes all your income, including K-1 income from anywhere. If the K-1 income is from an out-of-state business, you might also owe tax in the state where the business operates. To avoid double taxation, your resident state usually gives a credit for taxes paid to other states on that income. For example, you live in State A but are a partner in a partnership doing business in State B. State B will tax the partnership income sourced in State B (you might file a nonresident return for that).

• State A taxes all your income but should credit the tax you paid to State B. The net effect: you pay the higher of the two states’ tax rates on that income. Multi-state K-1s can be a headache – you might receive a schedule showing income allocated to various states. Be prepared to file multiple state returns if it’s significant money.

• Source Income for Nonresidents: States generally tax nonresidents on income earned within their borders. So, partnership or S corp K-1 income is considered sourced to a state if the business operates there. Each state has its own allocation/apportionment rules. Some states might source based on where the work is done or where the customers are. If you have a small K-1 amount in many states, sometimes you can skip filing in some (if under filing thresholds).

• But legally, if you have, say, $1,000 of income in State X, you’re technically supposed to file a return in State X and pay perhaps $50 of tax. Tip: Check state filing requirements; some states have de minimis exemptions for small amounts or the partnership might file a composite return on behalf of nonresidents.

• Entity-Level Taxes: A few states have quirks where they impose taxes or fees on pass-through entities themselves:

  • Franchise or Entity Tax: We mentioned California’s 1.5% tax on S corps (and a fee on LLCs based on gross receipts). Illinois charges a replacement tax on partnerships and S corps (1.5% or so). New York City imposes an unincorporated business tax (UBT) on partnerships (so NYC gets a cut at entity level). These don’t usually change the fact that the income flows to you; they’re just an extra cost. But from your perspective, those taxes paid by the entity might reduce the income flowing to you (since they’re deductible expenses at the entity level).

  • Pass-Through Entity Tax (SALT Cap workaround): Recently, many states (over 20 so far) enacted elective pass-through entity taxes. These allow a partnership or S corp to pay state income tax at the entity level (which is deductible federally), and then give the owners a credit or exclusion so they don’t double pay. This is designed to work around the $10k cap on state and local tax deductions.

  • If your business does this, your K-1 might show a state tax credit. For example, an S corp in New York may pay NY tax on your behalf and issue you a credit. You then don’t pay NY tax individually on that income. These PTE taxes vary widely by state – but it’s something to be aware of on your K-1 (usually indicated in the supplemental info of the K-1).

• Differences in Definitions: Some states don’t recognize certain federal provisions. For instance, a state might not allow the 20% QBI deduction (many states decoupled and tax the full amount). Or a state might treat passive losses differently.

• But for the most part, your state taxable income from a K-1 will mirror the federal, with some adjustments. One common adjustment: states often don’t tax municipal bond interest from their own state (fed doesn’t tax any muni interest, state only taxes out-of-state muni interest), and state might not allow some federal credits.

• Basis Tracking for State: If your state tax law differs (e.g., doesn’t allow bonus depreciation or certain deductions), your state basis in the partnership/S corp could diverge from federal basis. This gets complex: you might have a different gain or loss on sale or distribution in a state vs federal. Small differences year to year aren’t usually huge, but over time they add up. If you’re in a state like California, it’s wise to track state basis for your K-1 investments as well.

• Community Property States: If you live in a community property state and you or your spouse own a partnership interest, the income might be treated as jointly owned. This is more a marital property concept than a tax law difference, but it could affect how you split the income on state returns if filing separately.

• Trust/Estate State Tax: Trust income taxation by states can depend on the trust’s residency (often where it’s administered or where the grantor lived when it became irrevocable). Some states tax a trust if trustees are in-state or beneficiaries in-state. So a trust K-1 could have state tax implications in multiple states as well. If you’re a beneficiary, typically you pay tax in your state of residence on that income, and the trust’s state might not tax distributed income (it taxes only what’s retained). But again, it varies.

In short, state taxation of K-1 income generally follows the pass-through principle: the individual owner/beneficiary pays.

But you must consider multi-state reporting, possible entity-level charges, and state-specific adjustments. Always review any state-specific K-1 forms attached (many partnerships issue a state K-1 equivalent for your use). And remember, if you live in a state with no income tax (TX, FL, etc.), you luck out on the personal level – but you might still owe tax to other states if the income is sourced there.

Demystifying Tax Terms: Pass-Through, Basis, Passive vs Active, and More

K-1 taxation brings in a slew of tax jargon. Let’s clarify some of the most important terms and concepts that determine how (and whether) your K-1 distribution is taxed:

Pass-Through Taxation (Flow-Through Entities)

We’ve used this term repeatedly: pass-through (or flow-through) entities. This refers to businesses or financial entities that do not pay entity-level income tax. Partnerships, S corporations, and certain trusts qualify. Instead of paying tax themselves, they shift the tax liability to their stakeholders. The profits “pass through” to owners who report them. This is in contrast to a C corporation, which does pay corporate income tax on its profits and may then distribute after-tax profits to shareholders as dividends (which shareholders also tax – the classic double taxation).

• Why pass-through? Most small and medium businesses choose pass-through form to avoid double taxation and take advantage of a single layer of tax at (often) individual rates. Also, losses in a pass-through can potentially be used by the owners (subject to limitations), whereas C corp losses stay in the corporation.

• K-1 is the linchpin: The Schedule K-1 is how pass-through entities report each owner’s share. Unlike a W-2 or 1099 which are standard forms, K-1s can vary in format and often include attached statements (since they aren’t uniform beyond basic items) – but regardless of format, the function is the same: inform you and the IRS of your share of income.

• Think of a K-1 as a composite 1099 for owners: it might show many types of income (interest, dividends, capital gains, business income) all on one form. You then transfer those amounts to the appropriate places on your 1040.

• Tax liability shift: Because of pass-through treatment, an owner can owe tax on business income even if the business keeps the cash. This is a critical point: if you own part of a profitable LLC and they reinvest every penny, you’ll have to pay taxes out-of-pocket on your share of profits. Many operating agreements account for this by having the entity distribute at least enough cash to cover owners’ tax bills (often called a “tax distribution”). But it’s not legally required unless specified.

Basis – The Importance of Basis in K-1 Taxation

Basis is a fundamental concept for anyone receiving K-1s. In simplest terms, your basis in a partnership or S corp is your running investment balance for tax purposes. It starts with what you paid in (cash or property contributions). Each year, it’s increased by any income you’re allocated (because you’re being taxed on that income, essentially as if you retained it in the business) and decreased by any losses, deductions, and distributions allocated to you.

Why does basis matter? Two main reasons:

1. Loss limitation: You can’t deduct losses beyond your basis. If your basis goes to zero, further losses are suspended. For example, you put $10k into a partnership. Year 1 K-1 shows $12k loss. You can only deduct $10k (bringing your basis to zero); the extra $2k is suspended until you add basis or have profit later.

2. Distribution taxation: Distributions are not taxed so long as you have basis to cover them. They are considered a return of capital (lowering your basis). If you receive more in distributions than your basis, the excess is a taxable capital gain. For instance, if your basis in the partnership is $5k and you get a $8k cash distribution, $5k is tax-free (your basis goes to zero) and the extra $3k is a capital gain to report.

Partnership vs S Corp basis:

• In a partnership, your basis includes your share of liabilities of the partnership (recourse debts you have responsibility for, and in limited cases, nonrecourse debt for real estate). This means partnership basis can often be higher if the partnership borrows money that you’re on the hook for.

• In an S corp, shareholder’s basis does not include corporate liabilities (except direct loans from you to the S corp, which count as debt basis separately). So S corp owners can’t increase basis by bank loans to the company (unless they personally re-loan the funds into the company).

Basis tracking example (partnership): You invest $20,000 in a partnership. Year 1: K-1 shows $10k income and $5k distributed to you. Basis start $20k, +$10k income = $30k, -$5k distribution = $25k ending basis. You pay tax on $10k income. Year 2: K-1 shows $5k loss and $15k distribution. Basis $25k, -$5k loss = $20k, -$15k distribution = $5k ending basis.

You could deduct the $5k loss (basis was sufficient). The $15k cash you got isn’t taxed itself, but it reduced your basis. Year 3: K-1 shows $2k income, $10k distribution. Basis $5k, +$2k income = $7k, -$7k of the $10k distribution = $0 basis; the remaining $3k of distribution is beyond your basis – that $3k is a capital gain on your tax return. Basis remains $0 until more income or contributions occur.

Why you must track basis: The entity is required to track capital accounts and often provides a basis worksheet, but ultimately it’s the taxpayer’s responsibility to compute their own tax basis, especially for S corps (since the corporation doesn’t always know if you had outside basis adjustments). Tax software and CPAs will track this for you if done properly.

If you have a small partnership with no real business (say sharing a rental with a friend), there’s an option to elect out of subchapter K in some cases (if you each report your share without a partnership return). Most serious ventures will formalize via K-1, though.

Active vs. Passive Income (Material Participation)

Not all income is created equal in the tax world. Active (nonpassive) income and passive income are treated differently, particularly when it comes to losses and certain taxes. With K-1s, determining whether your share of income is passive or nonpassive is crucial:

• Active (Nonpassive) K-1 income: If you materially participate in the business (you meet one of the IRS tests for significant involvement, such as working 500+ hours a year in it), then the income is considered active. You can think of it like you’re running the business or very involved.

• Active K-1 income is not subject to the NIIT 3.8% tax, and losses from it can offset other nonpassive income (like wages or interest) freely. For example, you actively participate in a restaurant partnership and it has a loss – you may deduct it against your other income if you materially participated, up to basis/at-risk limits.

• Passive K-1 income: If you do not materially participate (e.g., you’re an investor who maybe checks in occasionally but doesn’t run day-to-day), your income is passive. Passive income itself is still taxable (no avoiding that), but passive losses are restricted. They typically can’t offset your active or portfolio income.

• They carry forward or can offset other passive incomes. Also, passive K-1 income is included in the base for the 3.8% Net Investment Income Tax if you’re above the income threshold if you’re a high earner. Passive losses, if unused, carry forward to use against future passive income or when you dispose of the interest.

• Examples:

  • You own 5% of a real estate LLC as a silent investor. The rental income on your K-1 is passive by definition (all rental income is passive unless you’re a real estate professional meeting strict criteria). If it shows a $10k profit, you pay tax on that, and if you’re high-income, it might incur NIIT. If it shows a $10k loss, that loss is passive and you can’t deduct it against, say, your salary – it carries forward to offset future passive income or when you sell the investment.

  • You and a friend start an online retail business as an S corp. You work 20 hours/week on it, your friend is hands-off. Your K-1 income is nonpassive (you materially participate), her K-1 income is passive to her. If the business loses money: you can deduct your share (subject to basis) against other income; she cannot currently deduct hers (unless she has other passive income).

  • Publicly Traded Partnerships (PTPs) like many energy MLPs: these are always passive to individual investors and have a special rule – passive losses from a PTP can only offset income from the same PTP, not other passive incomes. Unused losses carry forward to use against future income from that same partnership or upon sale.

• Why does it matter? Besides loss utilization, some credits and deductions apply differently. For instance, the 20% QBI deduction we mentioned generally only applies to income from an active trade or business (not to investment income like capital gains or interest passed through, and if you’re a passive investor, you still get it as long as the business qualifies). Also, state taxes: some states might allow passive losses even if federal doesn’t (rare, but a few states had different passive rules historically).

• Material participation tests: The IRS has seven tests. Common ones: 500 hours, or 100 hours and no one else does more than you, etc. There’s also special status for rental real estate with active participation (a lesser $25k loss allowance if you actively manage but aren’t a real estate pro). If you have significant K-1 losses, it’s worth consulting these tests or a tax advisor to see if you can qualify as active. The IRS does scrutinize this – taking big losses as nonpassive can be an audit flag.

• Self-employment tax connection: Typically, if it’s active (you materially participate in a partnership), then that income is likely subject to self-employment tax. If it’s passive (limited partner not involved), generally no SE tax. So passive vs active has a role in SE tax for partnerships. For S corps, SE tax isn’t on K-1 either way, but if you’re active you have the W-2 requirement.

• Why you must categorize: Loss limitations, additional taxes like the NIIT, and proper deductions hinge on correctly identifying whether your K-1 income is active or passive. Even if both types of income are taxed, how you offset losses or handle additional taxes like self-employment tax can vary dramatically.

Other Important Terms and Concepts

• Guaranteed Payments (for Partnerships): These are amounts paid to partners for services or use of capital, determined without regard to the partnership’s income (like a salary to a partner, or guaranteed interest on capital). They are reported on the K-1 separately. Tax-wise, guaranteed payments are generally ordinary income to the partner (and usually subject to self-employment tax) and a deduction to the partnership. If you see a guaranteed payment on your K-1, know that it’s taxed like a wage (but no withholding). It ensures a partner gets a minimum amount regardless of profit levels.

• Schedule K-3 (International Reporting): Starting tax year 2021, partnerships and S corps with foreign activities or partners may issue a Schedule K-3 (and K-2 for the entity) which reports international tax info (foreign income, taxes paid, etc.). If your K-1 includes foreign income or you paid foreign taxes through the entity, the K-3 provides the details for claiming foreign tax credits or meeting info reporting requirements. For example, if you invested in an overseas venture through a partnership, you might get a K-3 showing foreign dividend income and foreign taxes, which you’d use to fill out Form 1116 for a credit. If the K-3 is applicable, don’t ignore it – it’s part of the K-1 package for your taxes.

• UBTI (if in an IRA/401k): Unrelated Business Taxable Income – if you hold a partnership interest in a tax-deferred account (like an IRA), normally that shelter avoids current tax. But if the partnership generates active trade/business income (not just passive investment income), over $1,000 of UBTI can make the IRA itself owe taxes. While this is outside personal tax, it’s worth mentioning: K-1 in an IRA might trigger a Form 990-T filing by your IRA. This doesn’t affect most individuals’ 1040 directly, but it’s a gotcha if you invest your retirement account in partnerships.

• Filing requirements: Receiving a K-1 often means you may need to file additional forms:

  • Form 6198 (At-Risk) if losses are limited by at-risk rules.

  • Form 8582 (Passive Activity Loss Limitations) to compute allowed passive losses.

  • State K-1 forms or nonresident returns as discussed.

  • The K-1 itself is not attached to your return generally (if e-filing, you input the data; if paper, you typically don’t need to attach K-1s for 1040, except in special cases). The IRS gets a copy from the entity anyway.

  • If you have large partnership/S corp interests, be aware of possible Form 7203 (for S corp shareholder stock and debt basis tracking, new in 2021) if you claim losses or take distributions beyond basis.

By mastering these terms – pass-through, basis, active vs passive, etc. – you’ll better understand the mechanics of K-1 taxation and avoid costly mistakes (like thinking a distribution is “free money” or deducting a loss you’re not entitled to).

Examples: How 3 Common K-1 Scenarios Are Taxed (with Table)

Let’s bring theory to life with some concrete examples. Below we’ll walk through three typical K-1 scenarios and illustrate how the taxation works for each. For simplicity, assume federal tax rules and a single state that follows federal treatment, and that the individuals involved are U.S. tax residents.

Scenario 1: Partnership Partner Receiving K-1 Income and Distributions

The situation: John is a 50% partner in ABC Consulting Partnership, an LLC taxed as a partnership. He contributed $50,000 to start the business. In 2024, ABC earned $100,000 in profits. It distributed $60,000 cash to each of the two partners (John and his partner Jane) during the year.

John’s K-1: will show $50,000 of ordinary business income (50% of $100k). Let’s say there were also $2,000 of interest income earned by the partnership; John’s K-1 would have $1,000 interest. So John’s total taxable income from the K-1: $51,000. It will also show $60,000 distribution in the footnotes or capital account section.

Tax results for John:

• He reports the $50,000 business income on Schedule E of his 1040, and the $1,000 interest on Schedule B. All $51k is taxed at his ordinary income rates (interest is ordinary, and the business income is ordinary too).

• Self-Employment Tax: Because John materially participates (he works in the business full-time), the $50k of business income is subject to SE tax (approximately $7,065 in SE tax if $50k is below the Social Security wage base). The $1k interest is not SE taxable.

• The $60,000 cash distribution is not separately taxed. It’s a payout of profit that was already taxed (or return of capital). John’s basis: started at $50k, increased by $51k income = $101k, then $60k distribution reduces basis to $41k. No part of the distribution exceeded his basis, so no gain.

• John likely needs to pay estimated taxes, since no withholding was taken on that K-1 income. He may make quarterly tax payments to cover the income and SE tax.

In summary: John will owe income tax on $51k and SE tax on $50k. The distribution itself has no direct tax, but it provided cash to help John pay the taxes. John’s remaining basis $41k carries forward.

Scenario 2: S Corporation Shareholder – K-1 with Salary and Distribution

The situation: Lisa owns 100% of an S corp, TechCo, Inc. The S corp had $120,000 of profit in 2024 before owner compensation. Lisa, as an employee-shareholder, paid herself a W-2 salary of $50,000. After that, the S corp’s net profit is $70,000 (which will go on her K-1). The S corp distributed $60,000 cash to Lisa during the year.

Lisa’s taxes:

• W-2 Salary: She’ll get a W-2 for $50k. That’s taxed as normal wage income, and FICA taxes were withheld (so Social Security/Medicare on that $50k from her and the company).

• K-1 Income: Her 1120S K-1 shows $70,000 of ordinary business income (and maybe some small interest or depreciation items, but assume just $70k). She reports that $70k on Schedule E. It’s ordinary income to her and qualifies for the 20% QBI deduction (assuming TechCo is a qualified business and her personal income isn’t above phaseouts). So she might get a $14k deduction, making only $56k of it effectively taxable federally.

• No SE tax on the $70k. Because she took a salary (and paid payroll taxes on that), the remaining $70k K-1 income is not subject to SE tax or FICA. This saves her roughly $10,700 in Medicare/Social Security taxes compared to if all $120k were self-employment income (the exact savings depends on wage base limits, but conceptually significant).

• Distributions: The $60,000 distribution is not taxed. It’s coming out of the $70k profit that she’s already paying tax on via the K-1. Her basis: initially whatever capital she invested. Each year it goes up by K-1 income $70k, down by distributions $60k. So net basis increase $10k this year (assuming she had enough basis to begin with, which she likely did).

• If Lisa lives in a state with income tax, both her salary and K-1 income are taxed by the state. If in California, the S corp itself also paid 1.5% on the $70k (which is deductible federally by the S corp, slightly reducing the pass-through amount).

Takeaway: Lisa pays tax on $50k (wages) + $70k (K-1) as income. The K-1 portion gets favorable SE tax treatment (none), but she did pay some FICA on the wages. As long as her salary is deemed “reasonable” for her role, the IRS is fine with this split. The $60k distribution is tax-free to her (just reduces basis). If she had taken, say, $120k distribution and zero salary, the IRS would likely reclassify some of that as wages – which is why she wisely chose a salary.

Scenario 3: Trust Beneficiary – K-1 from a Family Trust

The situation: Maria is a beneficiary of her late grandmother’s trust. In 2024, the trust (an irrevocable family trust) earned $5,000 of interest and $5,000 of qualified dividends, for $10,000 total income. Per the trust terms, all income must be distributed annually to the beneficiaries. Maria gets 50% of the income, and her cousin gets the other 50%.

Maria’s K-1: from the trust (Schedule K-1 (Form 1041)) will show:

• Interest income: $2,500

• Qualified dividends: $2,500
  These are Maria’s share of the trust’s income categories.

Tax for Maria:

• She includes the $2,500 interest on her Schedule B just like any interest, and the $2,500 of qualified dividends on the dividend section of Schedule B (and gets the lower capital gains tax rate on those dividends because they’re qualified).

• The trust likely sent her $5,000 in cash to match that income (maybe it kept some small amount for expenses, but essentially $5k distribution).

• Maria will pay federal (and state) tax on that $5k of income. The trust will take a deduction for distributing that $10k total, so the trust itself pays no tax on it.

• If the trust had any capital gains that it did not distribute (say it sold some stock and reinvested), those gains would be taxed to the trust, not on Maria’s K-1. Her K-1 only reflects what the trust passed out.

• No self-employment or payroll tax issues here; it’s purely investment income.

If the trust didn’t distribute: Hypothetically, if the trust retained the income, Maria would get no K-1 (or maybe a $0 K-1) and the trust would pay the tax on the $10k (at trust rates, which are high – likely owing a few thousand in tax). But since it did distribute, Maria gets the K-1 and pays at her presumably lower rate.

Estate example: The same mechanism would apply if this were an estate of someone who died, during administration. The beneficiaries get K-1s for distributed income.

These scenarios show how K-1 taxation plays out. Let’s summarize them in a quick comparison:

Key takeaways: Regardless of scenario, K-1 amounts were taxed to the individual. The form of income (business vs investment) and the presence of payroll taxes differed. The partnership and S corp cases also highlight basis and distribution handling, whereas the trust case shows the flow-through of portfolio income.

Understanding these examples can help you map your own K-1 situation to the tax outcomes you should expect.

What to Avoid: Common Mistakes and 🚩 Audit Triggers with K-1s

K-1s can be complex, and it’s easy to slip up. The IRS does match K-1s to tax returns (often later by automated underreporter programs), and certain patterns can draw scrutiny. Here are some common mistakes to avoid and red flags to be aware of:

• 🚩 Failing to report a K-1 entirely: It sounds obvious, but since K-1s often arrive late (sometimes well after April 15 due to extensions), people might file their 1040 without including it. The IRS will get a copy of that K-1 from the entity, and if it doesn’t see the income on your return, you’ll likely get an automated notice months (or even a year or two) later for underreported income. Always wait for all K-1s or file an extension if necessary. If you’re missing a K-1, reach out to the issuer or at least make a good faith estimate on your return with disclosure.

• 🚩 Misreporting the character of income: K-1s break out different income types. A common error is to lump everything as ordinary income on Schedule E. For example, if your K-1 has $5k of interest and $5k of ordinary income, don’t put $10k on Schedule E – the interest goes on Schedule B. Or if it has capital gains, that goes on Schedule D (and gets favorable rates). Misclassification can cause you to overpay or underpay tax. Follow the K-1 instructions and labels carefully.

• 🚩 Not using passive loss rules properly: As discussed, passive losses are limited. If you take a large loss from a K-1 against other income without checking passive activity status, you might be incorrectly reducing your tax. The IRS may catch this in exam. Document your participation hours or status if you’re treating a loss as nonpassive. And if you have suspended passive losses from prior years, don’t forget to use them once you have passive income or dispose of the activity.

• 🚩 Ignoring basis limitations: Deducting losses or taking distributions beyond your basis is a big no-no. While the IRS may not catch a basis issue automatically (they don’t get basis info from K-1s), if you’re audited, this will surface. For S corp shareholders, the IRS now requires Form 7203 in many cases to report your basis if you claim a loss or distribution. In partnerships, the partner’s capital account on the K-1 (tax basis method) is a clue – if it goes negative, that might mean you took out more than you put in plus income, which can indicate taxable gain or an impermissible loss. Keep track of basis and don’t assume you can deduct all losses – especially if you only invested a small amount or prior distributions have been high.

• 🚩 Treating K-1 distributions as “tax-free” income: Some people mistakenly think if they get a distribution and it’s not labeled as taxable on the K-1, it’s like a free gift. Remember, the distribution isn’t taxed at that moment because either it’s returning your own capital or it’s paying out income you’re already taxed on via the K-1. Don’t confuse “not separately taxable” with “tax-free in the grand scheme.” The income was taxed via the K-1 allocation. A red flag would be someone who doesn’t report K-1 income because “I didn’t receive anything.” The IRS expects you to report the allocated income regardless of distributions.

• 🚩 Failing to file required additional forms: Complex K-1 items can trigger their own forms. If your K-1 shows foreign transactions (lines for foreign taxes paid, etc.), you likely need Form 1116 or other disclosures. If it shows you have “interest in a foreign partnership” or “foreign assets over $300k” in statements, you might need to file Form 8865 or FBAR/8938. Large tax shelter type losses might need Form 461 (excess business loss) or at-risk Form 6198. Not attaching these can cause IRS correspondence or deny the losses. Always read footnotes on K-1s for “Statement A, B, etc.” and follow any “Instructions to shareholder/partner” provided.

• 🚩 Late K-1 leading to amended returns: If you file your taxes and then get a K-1 in the summer, don’t ignore it. You should amend your return to include it. The IRS might catch it anyway, but voluntary amendment avoids penalties. To prevent this, many high-income individuals simply file an extension routinely if they expect late K-1s (partnerships often extend to Sept 15, issuing K-1s late summer).

• 🚩 Unreasonably low S corp salary: As mentioned with the Watson case, if you’re taking most of your S corp income as distribution rather than wage, you risk an audit. The IRS has published guidelines and actively pursues this in exams. Pay yourself a reasonable salary for your role and industry. This is one of the few areas where an S corp K-1 could directly trigger an audit if the numbers look skewed (e.g., S corp profit $500k, salary $10k – almost certain IRS target).

• 🚩 Large variances or unusual items: Big swings in income or loss, especially losses that significantly reduce your taxable income, can attract attention. The IRS might ask you to substantiate your basis or passive classification. If you suddenly have a huge K-1 loss from, say, a conservation easement partnership (a known tax shelter area), expect scrutiny. Or if you claim a hefty business credit from a K-1 (like R&D credit), they may inquire.

• 🚩 Not reporting state K-1 info: Don’t forget about state taxes. If your partnership gives you a K-1 showing, for example, $50k of income in a state you’re not a resident of, you likely need to file a nonresident return for that state. One common mistake is to report all the income on your home state return and not realize some should be taxed elsewhere (with a credit back home). This can lead to owing back taxes, interest, and penalties in the other state if discovered. Some partnerships do composite state filings or withholding on behalf of out-of-state partners – check your K-1 footnotes for any state tax withholding or payments made on your behalf, and claim those credits.

• 🚩 Assuming K-1 income is “like a 1099” without considering nuances: For example, some might get a K-1 from an investment fund and think it’s just like interest income. But K-1s can include things like Section 199A REIT dividends, Section 1231 gains, etc., each with special rules. If you ignore the details, you might miss a deduction or misreport. A sophisticated example: K-1 shows Section 1231 loss and capital gain – those have to be netted in a particular way on forms; missteps could either overstate or understate your tax.

In essence: Pay attention to what the K-1 is telling you, and follow through correctly on your tax forms. When in doubt, get professional help – CPAs deal with K-1 reporting all the time and can help avoid these pitfalls. The IRS expects you to keep records (like basis) even if the K-1 issuer doesn’t report it to them. By avoiding these common errors, you’ll greatly reduce your chances of an audit or tax notice related to your K-1 income.

K-1 vs. 1099 vs. W-2: How Does K-1 Income Compare?

You may wonder how K-1 income is different from the more familiar W-2 (wage) income or 1099 (miscellaneous income) forms. Here’s a quick comparison to put it in perspective:

• W-2 Income (Employee wages): If you’re an employee, you receive a Form W-2. Taxes are typically withheld from your pay throughout the year. W-2 income is always considered active earned income. It’s subject to Social Security and Medicare taxes (FICA), which your employer splits with you. The full amount is taxable to you as ordinary income. You don’t have to worry about basis or distributions – wages are just wages. W-2s also often bring benefits like health insurance or 401k, which can pre-tax reduce what shows up in box 1. With a W-2, your tax compliance is straightforward: plug the numbers into your 1040, you’re done. No Schedule E or complex forms needed.

• 1099 Income: “1099” can mean many things – Form 1099-NEC for independent contractor pay, 1099-INT for interest, 1099-DIV for dividends, 1099-B for brokerage sales, etc. Essentially, a 1099 form is an information return letting the IRS know you received some money. If you’re a freelancer or contractor, a 1099-NEC is your equivalent of a W-2 (but no taxes withheld, and you need to handle self-employment taxes). 1099 income might be active (if it’s from work you did, reported on Schedule C) or passive (interest, dividends).

How do these compare to a K-1?

• Nature of Income: A K-1 can actually encompass multiple types of income (interest, dividends, capital gains, rental income, etc.) all rolled into one form. A W-2 is basically one type (wages). A 1099-NEC is one type (self-employment earnings). So a K-1 is more multifaceted. It’s as if you got a bundle of various 1099s representing your share of each category from the entity.

• Withholding: Neither K-1 nor most 1099s have tax withheld (exceptions: 1099-R from retirement might, or backup withholding if info is missing). W-2 does have withholding. So K-1 recipients, like many 1099 recipients, often need to pay estimated taxes quarterly to avoid underpayment penalties. (The partnership or S corp might send you cash for “tax distributions,” but it’s on you to actually send to IRS.)

• Employment Tax: W-2 wages have half the payroll tax paid by employer and half by employee (via withholding). 1099-NEC self-employment income – you pay the full self-employment tax (equivalent of both halves). K-1 income: if from a partnership and active, you also pay the full self-employment tax on that share. If from an S corp, you pay yourself W-2 for part and the rest comes as K-1 not subject to SE tax. If it’s passive K-1 income (like you didn’t work for it), you might pay the 3.8% NIIT if you’re high-income, but no SE tax. So employment tax treatment is a distinguishing factor:

  • W-2: FICA handled via employer/employee.

  • 1099-NEC: SE tax on you fully.

  • K-1: depends on entity/role (it could be zero, partial, or full SE/FICA equivalent).

• Ownership vs Compensation: A W-2 or 1099 usually means you’re being compensated by someone but you don’t necessarily own anything (1099 could also be investment income, but the idea is it’s a payment). A K-1 means you are an owner or a beneficiary. It’s tied to an equity interest or a beneficial interest. This is why K-1 also includes things like your share of credits or your share of nondeductible expenses, etc., which a 1099 would never show. K-1 is about allocating items of a venture to those with a stake in it.

• Reporting on Tax Return:

  • W-2 goes on line 1 of Form 1040. Simple.

  • 1099-NEC goes to Schedule C (and then to 1040) if you’re self-employed, or other 1099s go to specific schedules (interest to B, dividends to B, capital gains to D, etc.).

  • K-1 requires Schedule E for partnership/S corp income (Schedule E Part II for partnership/S corp K-1s, Part III for trust K-1s). However, portions of the K-1 might also feed into Schedule B, D, etc., depending on what’s on it. It’s a bit more involved to correctly place everything.

• Timing and Format: W-2s and most 1099s are due to recipients by Jan 31. K-1s are often later (partnerships and S corps have a March 15 filing deadline, and many extend to September). So K-1 recipients frequently are still waiting for tax info when others have long received their W-2s/1099s. K-1 forms can also be quite lengthy (multiple pages with footnotes). A 1099 or W-2 is usually one page, standard format. K-1 formats can differ (especially for partnerships that issue custom statements) or for publicly traded partnerships.

To put it succinctly: a K-1 is more complex but also more informative – it tells the story of an owner’s share of a business’s activities. A W-2 or 1099 tells you about a specific payment or income type in isolation.

One isn’t “better” than the other in general – it depends on context. For example, $100k via K-1 (from an S corp) might result in lower employment taxes than $100k on a 1099-NEC, but it comes with more strings attached (having to run an S corp, file business returns, etc.). On the other hand, $100k on a K-1 from a partnership where you did no work is purely passive investment income – versus $100k on a 1099-INT which is interest – both are passive, but the partnership might have given you that via some business venture.

From a taxpayer experience perspective: W-2 is easiest (taxes handled, limited work), 1099 and K-1 both require more self-management and often mean bigger tax bills in April if you didn’t prepay. But K-1 indicates a more complex financial arrangement (ownership or inheritance), whereas 1099 could just mean you have a bank account that paid interest.

Pros and Cons of Receiving Income via K-1 📊

Should you rejoice or groan when you receive K-1 income? Let’s weigh the advantages and disadvantages of earning income through a pass-through entity (K-1) versus other means:

Pros:

• Single layer of tax: Unlike C corporation dividends (taxed at the corporate level, then again to you), K-1 income avoids double taxation. Generally, that means more of the pie ends up in your pocket. Pass-through taxation is efficient for small business owners.

• Potential tax savings on self-employment taxes: If structured as an S corp, as we saw, owners can draw part of income as distributions free of SE tax (with the caveat of reasonable wages). Even in partnerships, limited partners or investors don’t pay SE tax on their share. This can be a significant saving for high-income business owners compared to being a sole proprietor or LLC taxed as partnership where all income might be SE taxable.

• Flexibility in allocations (for partnerships): Partnerships can specially allocate items in certain cases (as long as rules for economic effect are met). This can allow tax optimization – e.g., allocating more taxable income to a partner who can absorb it (maybe they have losses or lower bracket) and more deductions to another who can utilize them. Family partnerships sometimes do this within IRS limits.

• Use of losses: If you materially participate and have sufficient basis, K-1 losses can offset other income (subject to some limits). This can reduce your overall tax bill. For instance, real estate professionals can use rental losses (via K-1s or directly) to offset wage income. Or a business owner who also has a day job can use initial business losses passed through to reduce taxes on the day job income. With a C corp, losses stay in the corporation; with a pass-through, they can potentially benefit the individual.

• 20% QBI Deduction: Many K-1 incomes qualify for the Qualified Business Income deduction, effectively lowering the tax rate on that income by one-fifth. W-2 wages don’t get this, nor do pure investment incomes like interest (unless from REIT or PTP with their own QBI rules). This was a big boost from the 2017 tax law for pass-through income.

• Estate planning and income splitting: Trusts and family partnerships (FLPs) can distribute income among family members via K-1s, which might put income in lower tax brackets of multiple people rather than all in one person’s bracket. Also, K-1 interests can be gifted or passed through estate with valuation discounts (for partnerships) etc., providing estate tax benefits.

• Tax deferral in some cases: If the entity reinvests profits, you still pay tax currently – HOWEVER, consider a scenario like a real estate partnership that has heavy depreciation: the taxable income on the K-1 might be low or zero, while cash flow is positive (depreciation sheltering income). You effectively got cash distribution with little tax – deferring tax until property sold (when gain is recognized, possibly at favorable capital gains rates). Many MLPs (Master Limited Partnerships) operate this way – they pay high distributions but report low income due to depreciation, so investors enjoy deferral and lower current tax.

Cons:

• Complexity and compliance burden: K-1s complicate your tax life. Multiple K-1s can mean a lot of record-keeping, forms, and potentially professional help needed. There’s a cost (time/money) to handling K-1 taxes versus say a simple W-2 only return. Also, K-1s can introduce you to concepts like AMT (certain preference items), state filings, etc., that you wouldn’t deal with otherwise.

• Tax liability without cash in hand: K-1 income can create phantom income situations. You might owe tax on profits that you didn’t actually receive because the business retained them. This can hurt your personal cash flow – you might have to dip into savings to pay a tax bill. Owners need discipline to set aside money or ensure the company makes tax distributions.

• Exposure to additional taxes: Depending on the situation, K-1 income can trigger self-employment tax (which wage earners might not pay beyond a point if they’re not self-employed) or the NIIT for passive income. High earners with only wages might avoid NIIT, but if they have large passive K-1 income, they get hit with 3.8% extra. So K-1 could bring in taxes that a straight salary or interest income of a similar amount might not, given thresholds and exceptions.

• Timing issues and extensions: K-1s are notorious for coming late. If you have investments like private equity or hedge funds (often issuing K-1s), you almost always end up extending your return. Some people don’t like filing extensions (even though it’s not harmful if you pay what you owe by April). It can be an inconvenience.

• Audit risk in certain cases: While any income can be audited, partnerships are facing increased IRS focus (the IRS has new centralized partnership audit regime). Certain tax shelters use partnerships, so the IRS is on the lookout. As an individual, having a complex K-1 might slightly increase your chance of inquiry compared to a vanilla return. That said, being diligent mitigates this, and W-2s can be audited too for other reasons.

• Lack of liquidity & control: If you’re a minority partner, you can’t just decide “I don’t want this K-1 income” – you’re along for the ride unless you sell your interest. With a job (W-2) or a freelance gig (1099), you can quit or stop taking gigs. With a K-1 investment, you might have money tied up in a business and have to pay tax each year even if you can’t easily exit or sell your share.

• State tax hassle: As noted, multi-state K-1s are a pain. You might file multiple state returns or deal with K-1s from states you never set foot in (e.g., an MLP operating in several states). While often the amounts per state are small, technically you have to comply. Meanwhile, if you only had W-2 from one state, or 1099-INT from a bank, you wouldn’t have that issue.

• Assuming K-1 income is “like a 1099” without considering nuances: For example, some might get a K-1 from an investment fund and think it’s just like interest income. But K-1s can include things like Section 199A REIT dividends, Section 1231 gains, etc., each with special rules. If you ignore the details, you might miss a deduction or misreport.

• Not filing required additional forms: Complex K-1 items can trigger additional forms. Missing these forms can cause IRS correspondence or denial of deductions.

• Unclear communication or errors: K-1s sometimes come with supplemental statements or unusual allocations. Not reading these carefully can lead to mistakes on your return. Double-check all footnotes and instructions on the K-1 to ensure nothing is overlooked.

Key IRS Forms Connected to K-1s (1065, 1120S, 1041 and more)

When you receive a K-1, it’s the byproduct of another tax form that the entity filed. Here’s how the puzzle pieces connect:

• Form 1065 (U.S. Return of Partnership Income): This is the tax return for partnerships (and LLCs taxed as partnerships). Inside Form 1065 is a Schedule K, which aggregates all the partnership’s income, deductions, and credits for the year. Schedule K-1 (Form 1065) is then produced for each partner to report that partner’s share. The K-1s together essentially break up the Schedule K according to ownership percentages or special allocations. The partnership must file Form 1065 (typically by March 15, or Sept 15 on extension) and provide K-1s to partners by that time. Form 1065 is an information return – no tax is paid with it. However, if the partnership has certain types of income (like withholding on foreign partners or backup withholding), it might remit those on 1065. If you’re a partner, you don’t file anything called 1065; you just use the K-1 from it on your 1040. But note, general partners must also receive the 1065 package including things like the partnership’s financial statements (it’s good to review those to see what’s behind the K-1 numbers).

• Form 1120S (U.S. Income Tax Return for an S Corporation): This is the return for S corporations. Similar structure: it reports corporate income and deductions, and it has a Schedule K and Schedule K-1s for each shareholder. Each shareholder’s K-1 (Form 1120S) shows their share of items. The S corp doesn’t pay federal tax (except in special cases like built-in gains or excess passive income tax for S corps with C corp earnings). The 1120S is due March 15 (or Sept 15 extended). If you’re an S corp shareholder, you should also get a copy of the corporate tax return or at least the K-1 with supplemental info. The 1120S also requires the corporation to report each shareholder’s stock basis and debt basis at least in supplemental statements (and now shareholders file Form 7203 for basis tracking when needed).

• Form 1041 (U.S. Income Tax Return for Estates and Trusts): Trusts and estates file this if they have income above a small threshold. They pay tax on any income not distributed to beneficiaries. The Schedule K-1 (Form 1041) goes to beneficiaries to tell them and the IRS how much income was distributed. 1041 returns are typically due April 15 (or Oct 15 on extension) for calendar-year trusts, and a bit later for estates (estate can choose a fiscal year). As a beneficiary, you may get the K-1 well into the year if the fiduciary extends the return. Note, an estate/trust might have to issue a K-1 for a beneficiary even in the year the estate is wrapping up (distribution of assets in kind can carry out DNI as well).

• Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships): If you are a U.S. person who directly owns a significant interest in a foreign partnership, you might have to file Form 8865 (it’s like the equivalent of being the one responsible for the partnership return to the IRS). This is not super common unless you deliberately invested abroad in a partnership or LLC.

• Form 8805 & 8804 (Foreign partner withholding): If a partnership has foreign partners, it might withhold tax on their effectively connected income and send forms 8805 to show amounts withheld. If you’re a U.S. partner, you might never see these, but if you are a foreign partner, your K-1 might come with a Form 8805 showing taxes paid on your behalf.

• State K-1 equivalents: Many states have their own K-1 forms accompanying the state partnership/S corp return. For example, California has its own version for partners/shareholders, New York has its own form for partnerships, etc. If you have to file a nonresident state return, you often attach a copy of that state’s K-1 to show your income from that state’s sources.

• Schedule E (1040): This isn’t an entity form but it’s where a lot of K-1 info goes on your personal return. Schedule E, Part II is titled “Income or Loss From Partnerships and S Corporations.” You list each K-1 entity, EIN, and your share of income or loss. Schedule E, Part III is for “Income or Loss From Estates and Trusts” – where you list each trust/estate K-1. The totals from Schedule E flow into your Form 1040. If you have passive losses, Schedule E interacts with Form 8582 (passive loss limitations).

• Form 8960 (NIIT): If you are subject to the Net Investment Income Tax, this form calculates it. K-1 income (passive business income, rental, interest, etc.) would be included here.

• Form 4797 (Sales of Business Property): Sometimes a K-1 will have Section 1231 gains/losses (from sales of business assets). These get reported on Form 4797 then flow to Schedule D or 1040. The K-1 footnotes will usually guide you (like “section 1231 gain $X”).

• Form 6252 (Installment sales): If the partnership had a big sale and is receiving payments, your K-1 might have info on an installment sale, which you may need to continue reporting in future years.

• Special forms: There may be additional forms like Form 6781, 8949, etc., for specific items if the K-1 has certain items (like section 1256 contracts, or capital loss carryovers in final year) – these are less common, but advanced K-1s from investment partnerships might require them.

• 1065/1120S Schedule K-3: If there are foreign activities, the entity might give you a K-3. The K-3 is an extension of the K-1 focusing on international tax info. If you’re a purely domestic owner, you might not get one (or you get a statement that it’s not applicable).

So, the K-1 is your link to these entity-level forms. It tells you “hey, this partnership filed a 1065, and here’s your slice of it” or “this trust filed a 1041, here’s what you got.” If you’re ever unsure what some number on a K-1 is, sometimes checking the entity’s return (if you have access to a partnership’s Form 1065, for example) can help clarify. The IRS instructions for Schedule K-1 of each form are actually quite useful if you have a particularly confusing K-1 item – they explain what each line means.

For most individuals, you don’t need to fill out 1065/1120S/1041 yourself (unless you are in charge of that entity). You just use the K-1 from them. But understanding those forms helps to know why the K-1 has certain codes and lines. The IRS instructions for each K-1 are designed to ensure the income is reported properly.

Finally, note that these forms (1065, 1120S, 1041) have due dates earlier than your 1040 in most cases. So if you are expecting a K-1 and haven’t gotten it, it’s often because the entity extended its return. They might not get you the K-1 until the fall. In that case, you’ll likely extend your 1040 as well.

Court Case Precedents That Shaped K-1 Taxation ⚖️

Over the years, a number of court cases have clarified how K-1 income is taxed and what is (or isn’t) allowed. Here are a few landmark decisions and what they mean for K-1 recipients:

• United States v. Basye, 410 U.S. 441 (1973): This U.S. Supreme Court case established that partners are taxable on income even if it’s not distributed directly to them. In Basye, a medical partnership had a portion of its fees paid into a retirement trust for the partners. The partners argued that since they never saw that money (it went to the trust for their eventual benefit), it shouldn’t be taxable to them currently. The Supreme Court disagreed, holding that the amounts contributed to the trust were taxable income to the partners in the year earned, because it was earned for their benefit. This case underscores the principle that allocation equals taxation – a core idea behind K-1 income. Impact: If you think you can route your partnership income somewhere and avoid tax, Basye says no. For K-1 folks, it’s why you have to pay tax on income you might not personally receive.

• Renkemeyer, Campbell & Weaver, LLP v. Commissioner (2011): This Tax Court case dealt with a law firm LLP where the partners tried to claim most of their income was not subject to self-employment tax by allocating it to a partnership interest that they said was “limited.” The court looked at the substance: the partners were actively performing services (lawyers working in the firm), so they couldn’t skirt SE tax by that allocation. The court concluded that the limited partner SE tax exclusion applies only to those who “merely invested” and not to those actively providing services. Impact: This case makes it clear that if you actively work in a partnership, your K-1 income likely faces SE tax. It also set a precedent for using a “functional analysis” – looking at what you do, not just your title, to determine SE tax. For anyone receiving a K-1 from an LLC or partnership, if you’re trying to determine SE tax, this case is instructive: just calling yourself a limited partner isn’t enough if you indeed run the show.

• David E. Watson, P.C. v. United States (2012): This case involved an accountant who structured his one-man practice as an S corp and paid himself only $24k salary while taking out $200k+ as distributions to avoid payroll taxes. The courts upheld the IRS’s reclassification of a large portion of those distributions as wages. The court agreed that the salary was unreasonably low and that the IRS’s determination of reasonable compensation was valid. Impact: It’s the seminal case on reasonable compensation for S corp owners. This case is why S corp owner-operators must be careful in setting salary vs. distributions. It’s effectively a warning that abusing the S corp payroll tax advantage can be reversed by the IRS.

• Gitlitz v. Commissioner, 531 U.S. 206 (2001): An older Supreme Court case involving S corp cancellation-of-debt (COD) income. Without diving too deep: at the time, an S corp had canceled debt income which was excluded from taxable income but still increased shareholders’ basis, allowing them to deduct suspended losses. The Supreme Court allowed this result. Congress later closed the loophole with legislation (so now excluded COD doesn’t increase basis). Impact: It was a taxpayer win showing how S corp basis and income item nuances can have big effects. Post-Gitlitz law change means if an S corp has tax-exempt income (including excluded COD), it won’t give basis for losses. But the case is a classic example of how pass-through rules can produce unexpected outcomes and how Congress may step in if something seems like a loophole.

• Estate of Strangi v. Commissioner (various, early 2000s): These cases involve family limited partnerships (FLPs) and how they’re valued or treated in estates. The IRS sometimes argues an FLP is just holding assets for an elderly person and should be disregarded (under certain provisions). The courts have been mixed. Impact: While these are more estate tax cases, they affect K-1 entities since many FLPs issue K-1s to family members. The cases basically say: if an FLP is used but the original owner still treated assets as personal, the IRS can disregard it for estate tax purposes. For income tax, FLPs still function as partnerships. So if you’re a beneficiary receiving K-1s from an FLP, just know these entities get scrutiny in the estate context. It doesn’t change how you’re taxed on the income, but could affect estate planning outcomes.

• Cases on passive losses: There have been many cases disallowing passive loss claims where a taxpayer did not materially participate as required by the IRS tests. These cases emphasize that loss claims must align with participation tests, and aggressive claims may be challenged.

• Basis-related cases: Several decisions have reinforced that you only get basis when you actually make an economic outlay, not through circular arrangements or guarantees. This is critical when considering deductions or recognizing gains on distributions exceeding basis.

Each of these cases adds to the tapestry of how K-1 taxation works:

• Basye told us you can’t avoid tax by redirecting income.

• Renkemeyer told us you can’t avoid SE tax by nominal titles if you actually work.

• Watson told us don’t underpay yourself in an S corp.

• Gitlitz highlighted the interplay of pass-through income types and basis, though later changed by law.

• Strangi and similar tell us the IRS watches family partnerships in estate contexts.

• Passive loss and basis cases instruct the importance of following the rules strictly.

For most people, the practical lessons are: report your K-1 income fully, respect the tax rules (especially for losses and SE tax), and don’t get too aggressive without expecting a challenge.

Staying on the right side of these precedents means your K-1 experience will be much smoother.

The Role of Key Players: IRS, Tax Software, CPAs, and Business Structure Choices

Finally, let’s consider the bigger picture – who or what helps ensure K-1 income is handled correctly and how business structure decisions come into play:

• The IRS: The IRS creates the rules and forms that govern K-1s. They require partnerships and S corps to file those returns and issue K-1s. The IRS uses K-1 data in its computer systems to cross-check individual returns. They also publish guidance (like Partner’s Instructions for Schedule K-1 and Shareholder’s Instructions for S corp K-1) to help taxpayers understand the forms. The IRS’s role is also enforcement – through audits and notices. For instance, the IRS may run a K-1 matching program (similar to how they match W-2s/1099s) to find underreported K-1 income. They also audit complex partnership arrangements; recent funding increases enforcement on higher-earning taxpayers, which likely includes those involved in partnerships. Moreover, the IRS sometimes issues Private Letter Rulings or other guidance on particular K-1 issues (like how certain income should be reported). Bottom line: the IRS is the referee – they set the game rules (within the law’s framework) and call fouls if you break them.

• Tax Software: Gone are the days when many people did K-1 calculations by hand – now tax software (TurboTax, TaxAct, etc., or professional software like Lacerte, UltraTax) do much of the heavy lifting. Tax software can import K-1 data or have K-1 worksheets where you input each line from the K-1. They handle the allocation to correct forms (Schedule B, D, E, 4797, etc.) which is a godsend given the complexity. They’ll also carry over passive loss carryforwards year to year, track AMT versions of K-1 items, and some even help track basis (though basis tracking is often outside the scope of basic consumer software). However, software is only as good as the info you enter. Many K-1s come with supplemental statements (like code “AH: Other information” might have a footnote “Interest expense on investment loans $500” or something). You must manually incorporate those where needed. If you input wrong numbers or skip entries, the software won’t know. Also, not all software handles every obscure K-1 scenario gracefully. For example, some struggle with tiered partnerships (K-1s that feed into others) or publicly traded partnership basis adjustments on sale. That said, for the vast majority, using a tax program greatly reduces errors. It will also usually prompt you with questions (like “Is this income passive or nonpassive?” for the K-1 input) to properly apply rules. If you use a CPA, they will use their own software to do this for you.

• CPAs/Tax Preparers: K-1s are bread and butter for CPAs. A knowledgeable tax professional can decipher K-1 footnotes, apply the latest regulations, and advise you on strategies (like whether an election or grouping makes sense to treat something as active, or if an obscure deduction is allowable). They also help with basis calculations annually, ensure you don’t run afoul of things like at-risk rules, and can represent you if the IRS questions something. For people with multiple K-1s or very high income, having a CPA prepare your return can provide peace of mind, given what’s at stake. CPAs also often prepare the partnership/S corp returns that issue K-1s. They play the intermediary – making sure the K-1s are correct in the first place. A mistake at the entity level will flow down to all the K-1s, so competent preparation there is key. If you’re both an entity owner and an individual taxpayer using the same CPA firm, they can coordinate the information seamlessly. In summary, CPAs are the experts who ensure compliance and optimize wherever possible within the rules.

• Business Structures & Planning: The type of entity you choose for your business or investment dictates whether you even get a K-1. For example, if you operate as a sole proprietor or single-member LLC (not electing S corp), there’s no K-1 – you just have Schedule C. If you form a partnership or multi-member LLC, you’ll have a 1065 and K-1s. If you incorporate, you might choose S corp (1120S & K-1s) or C corp (no K-1, just corporate tax and possibly 1099-DIV for dividends). So a huge part of “K-1 or not” is the structural decision:

  • Partnership vs S Corp: Partnerships allow special allocations and flexibility, and can allocate debt basis to owners (useful for real estate), but have SE tax on active income. S corps have that payroll tax advantage but more rigid rules (only one class of stock, allocations by percentage only, limited shareholders, etc.). Also, adding/removing owners from partnerships is often simpler (no need to worry about terminating S election, etc.). Many small businesses start LLC (treated as partnership) for ease, some switch to S corp when profits grow to save on SE tax. It’s a trade-off and a planning decision often made with a CPA’s input.

  • Trusts vs outright inheritance: If assets are in a trust, that trust might file a 1041 and issue K-1s instead of, say, just giving you assets outright to own (which might then produce 1099s directly to you). Trusts can have their own reasons (control, asset protection, etc.), but from an income tax perspective, a complex trust means K-1s and higher trust tax if not distributed. Some estate planners try to distribute all income to avoid the trust paying high tax rates – using the trust as a conduit (much like a partnership).

  • Publicly Traded Partnerships vs Corporations: Some investment products give you K-1s (e.g., MLPs in energy, certain ETF-like vehicles structured as partnerships) whereas others give 1099s (mutual funds, REITs, stocks). Investors might shy away from K-1 investments due to hassle. There are discussions online about “I love the yield on this MLP but hate waiting for K-1s.” So business structures influence investor behavior too.

  • Choice of Tax Year: Partnerships/LLCs generally must use calendar year unless they have a business reason otherwise (or make a special election). Trusts can be calendar or fiscal (estate can choose). S corps are calendar unless a valid reason. The tax year of the entity affects when you get the K-1 and which year it applies to for you.

In essence, business structure is the cause, and K-1 is the effect. The IRS administers the whole system; tax software and professionals help navigate it. Good planning can mitigate the downsides (like incorporating for the right reasons, or electing out of partnership treatment if eligible under certain rules to avoid filing, etc.).

One specific tip: If you have a small partnership with no real business (say sharing a rental with a friend), there’s an option to elect out of subchapter K in some cases. It’s narrow when it applies, but it’s a way to avoid a 1065/K-1 filing requirement for very simple jointly-owned property. Most serious ventures will formalize via K-1, though.

Lastly, communication between these players is key. The business (through its CPA) needs to get K-1s out to owners; owners need to give their CPAs all K-1s received; software needs the data input correctly. If something looks off (like a huge income number that you weren’t expecting), query it – maybe the K-1 had an error and an amended one will be issued. Businesses do issue amended K-1s at times if mistakes are found. That’s another reason to possibly extend personal returns if something seems provisional.

By understanding each party’s role – the IRS as rulemaker/enforcer, software as a tool, CPAs as advisors/compliance experts, and your own business structure as a determinant of how you’re taxed – you can better manage your K-1 related obligations and decisions.

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FAQ: Are K-1 Distributions Taxed? (Quick Answers)

Q: Are K-1 distributions taxable income to me?
A: Yes. The income reported on a K-1 is taxable to you on your personal return, even if the business didn’t actually pay you cash. (You pay tax on your share of earnings.)

Q: Do I pay tax even if I didn’t get any cash distribution?
A: Yes. K-1 allocations are taxable regardless of cash received. It’s possible to owe tax on “phantom” income if profits were reinvested rather than distributed.

Q: Are cash distributions from a K-1 ever taxed separately?
A: No, not if they’re within your basis. Distributions up to your investment (basis) are not taxed; they’re considered a return of capital. Only distributions beyond basis are taxable gains.

Q: Can K-1 income be tax-free?
A: No, not generally. Most K-1 income is taxable. An exception is if the entity’s income is tax-exempt (like muni bond interest); that would flow out tax-exempt.

Q: Is K-1 income subject to withholding?
A: No. K-1 income usually has no withholding taken out. You may need to pay estimated taxes quarterly to cover the tax on K-1 income.

Q: Do K-1 recipients pay self-employment tax?
A: Yes, if it’s from an active partnership business. Active partners pay self-employment tax on their share. S corp K-1 income is not subject to SE tax (but those owners pay themselves wages separately).

Q: Does K-1 income get taxed twice?
A: No. K-1 income is only taxed to the owner once. The business itself doesn’t pay tax on it. (Double taxation can happen with C corp dividends, but not with pass-through K-1 income.)

Q: Is K-1 income considered earned income (for IRA or Social Security)?
A: Generally no. K-1 income from a business is not “earned” for IRA contributions, except wages or guaranteed payments. But it does count for Social Security earnings if subject to SE tax.

Q: Do I need to attach the K-1 form to my tax return?
A: No (in most cases). Keep the K-1 for your records. You report the data on your 1040 schedules. The IRS already gets a copy of the K-1 from the entity.

Q: Can K-1 losses reduce my other income?
A: Yes, if not passive and you have basis. Losses can offset other income if you actively participate and have sufficient basis/at-risk. Passive losses only offset passive income (or carry forward).

Q: Do states tax K-1 distributions?
A: Yes, if the state has income tax. Your resident state taxes all your income (including K-1). Other states may tax K-1 income sourced there, requiring nonresident returns (with credits to avoid double tax).

Q: Is K-1 better than 1099 for taxes?
A: It depends. K-1 income can get the 20% pass-through deduction and no double tax, but may involve self-employment tax. 1099 income (like interest) might be simpler but lacks those deductions.

Q: What happens if I don’t receive a K-1?
A: You should contact the entity or consider filing an extension. You’re still responsible for reporting the income. If you can’t get it by the deadline, file an extension or estimate and amend later.

Q: Does a K-1 mean I own part of a business?
A: Yes. A K-1 is issued to owners/partners/shareholders or beneficiaries. It signifies you have an equity or beneficial interest in that entity or arrangement.

Q: Are K-1 distributions taxed as capital gains?
A: Only if they exceed basis. Regular K-1 income is taxed per its nature (often ordinary). A distribution beyond your basis in the entity is taxed as a capital gain event.