Is a K-1 Really Taxable? Avoid this Mistake + FAQs

Yes, K-1 income is taxable.

The IRS treats income reported on a Schedule K-1 as taxable to the recipient, whether you are an individual taxpayer or a business owner. Schedule K-1 forms are used in U.S. tax law to report each recipient’s share of income from pass-through entities like partnerships, S corporations, and trusts.

That means if you receive a K-1, you usually owe taxes on the income it shows.

Roughly 30 million K-1 forms are issued each year to partners, S corporation shareholders, and trust beneficiaries, reflecting over $1 trillion in pass-through income.

Yet many taxpayers remain unsure how this income is taxed or reported. Below, we break down everything you need to know about K-1 taxable income.

• Partnership vs S Corp vs Trust K-1s: Discover how tax rules differ for K-1s from partnerships, S corporations, and trusts, including who pays the tax and when.

• Federal & State Tax Impacts: Learn how K-1 income is taxed at the federal level and what to watch for in state taxes (especially if your K-1 spans multiple states).

• Reporting & Planning Strategies: Find out how to report K-1 income on your personal tax return, manage self-employment tax, and plan for estimated taxes or deductions like the 20% pass-through deduction.

• Avoiding K-1 Tax Pitfalls: See real-world examples and common mistakes—such as being taxed on income you didn’t receive (phantom income)—and how to avoid costly errors.

• Benefits and Drawbacks: Understand the pros and cons of pass-through K-1 income versus other income types, helping you leverage tax benefits and sidestep drawbacks.

What is a Schedule K-1? (Pass-Through Taxation Basics)

A Schedule K-1 is a tax form used to report an individual’s share of income, deductions, and credits from certain entities. It is prepared by pass-through entities – businesses or trusts that don’t pay income tax at the entity level. Instead, these entities “pass through” their income to the individuals who own or benefit from them. Each owner or beneficiary receives a K-1 showing their allocable share of the entity’s taxable items.

Key pass-through entities that issue K-1s include:

• Partnerships – which file a Form 1065 partnership return and issue K-1s to partners.

• S Corporations – which file a Form 1120S corporate return and issue K-1s to shareholders.

• Trusts and Estates – which file a Form 1041 fiduciary return and issue K-1s to beneficiaries.

The IRS (Internal Revenue Service) requires that the income on a K-1 be included on the recipient’s personal tax return (Form 1040 for individuals). Unlike a Form W-2 (for wages) or Form 1099 (for interest or dividends), a K-1 usually does not involve tax withholding. It reports various categories of income (such as ordinary business income, interest, dividends, or capital gains) that retain their tax character when passed through.

In practical terms, receiving a K-1 means you are responsible for paying the tax on your share of the entity’s income. This holds true even if the income wasn’t actually distributed to you in cash. K-1 income is taxed in the year it’s earned by the entity, not necessarily when you receive a payment.

K-1 pass-through taxation also means the business or trust itself generally pays no income tax on that income. This avoids the double taxation that regular C corporations face, where profit is taxed at both the corporate and shareholder levels. Instead, the income is taxed only once—on the individual owner’s or beneficiary’s return.

Partnership K-1 Income – Tax Rules Every Partner Should Know

How Partnership K-1 Income is Taxed

If you’re a partner in a partnership (or a member of a multi-member LLC taxed as a partnership), you will receive a Schedule K-1 (Form 1065) reporting your share of the partnership’s income.

You must report that share on your own tax return and pay tax on it. Importantly, this distributive share is taxable to you even if the partnership doesn’t actually distribute the cash.

You could be taxed on partnership profits that were reinvested or used to pay partnership expenses. (The U.S. Supreme Court confirmed this in Commissioner v. Basye, 410 U.S. 441 (1973), holding partners taxable on income even if not received.)

Example: Taxed on Partnership Profit You Didn’t Receive

Imagine you own 50% of a partnership that earned $100,000 in profit this year. The partnership might retain that money for expansion instead of paying it out. You will still receive a K-1 showing $50,000 as your share of taxable income, and you must pay taxes on that $50,000. This scenario is sometimes called “phantom income” – being taxed on income you never actually received in cash.

Self-Employment Tax on Partnership Income

Partnership K-1 income may also be subject to self-employment tax, which covers Social Security and Medicare taxes for self-employed individuals. If you are a general partner or an active LLC member, the IRS typically treats your share of ordinary business income (and any guaranteed payments) as self-employment income.

That means it can be subject to an additional ~15.3% tax (the self-employment tax rate) on top of regular income tax. By contrast, limited partners (and members who are purely passive investors) usually are not subject to self-employment tax on their share of partnership income (except on any guaranteed payments for services), though the rules can get complex for LLCs.

Losses, Deductions, and Basis Limits for Partners

Not all K-1 items increase your tax – partnerships can also pass through losses, deductions, and tax credits to partners. If your partnership had a loss, your K-1 could show a negative income or specific deductions (like depreciation or a Section 179 expense) allocated to you. These can potentially offset other income on your return, but there are important limitations:

• Basis Limitation: You can only deduct partnership losses up to your basis in the partnership. Your basis generally equals what you invested plus prior years’ income allocations (and debt you’re responsible for), minus prior losses and distributions. If losses exceed your basis, the excess is suspended (carried forward) until you have enough basis in a future year.

• At-Risk Rule: Tax law also limits losses to the amount you have “at risk” in the business. For example, if part of your investment is protected by non-recourse loans (where you’re not personally liable), you might not be allowed to deduct losses beyond the amount at risk.

• Passive Activity Rule: If you do not materially participate in the partnership’s business (e.g. you’re a passive investor), losses may be classified as passive losses. Passive losses generally can only offset passive income (from other investments or rentals), not your salary or active business income. Any unused passive losses carry forward to future years (or until you have a year with passive income or you sell the investment).

• Credits: Tax credits (for example, a research credit or low-income housing credit) passed through on a K-1 can offset your tax, but often come with their own limitations (e.g. you can’t take more credit than your tax liability, and some credits have carryforward rules).

Partnership Distributions vs. Taxable Income

It’s crucial to distinguish between taxable income and actual cash distributions in a partnership. A common misconception is that if you withdraw money from the partnership, it’s automatically taxable income. In reality, distributions from a partnership are usually not taxed at the time of distribution, as long as you have sufficient basis. Distributions are generally viewed as a return of capital or profits that have already been taxed (or will be taxed via the K-1 allocation). When you receive a distribution, it reduces your basis in the partnership.

However, if you receive cash distributions in excess of your basis, that excess amount is treated as a capital gain (which is taxable). On the other hand, when the partnership allocates income to you on the K-1 (without an immediate distribution), you still pay tax on that income for the year, but your basis increases by the allocated income. That basis increase will prevent double taxation later when you eventually take out those profits as distributions. In summary, you pay tax on partnership income when it’s earned (per the K-1), not necessarily when cash changes hands.

S Corporation K-1 – Tax Benefits & Pitfalls for Shareholders

How S Corp K-1 Income is Taxed

If you are an owner of an S corporation, you receive a Schedule K-1 (Form 1120S) each year reporting your share of the company’s income, losses, and credits. Like partnership income, S corporation income passes through to owners and is taxed on their personal returns. You pay income tax on your share of the S corp’s profits for the year, regardless of whether the money was actually distributed to you. However, S corporations have some unique tax features that differ from partnerships.

No Self-Employment Tax on S Corp Income (But Salary Rules Apply)

One major advantage of S corporation income is that it is not generally subject to self-employment tax. Unlike a partnership (where active partners pay self-employment tax on business earnings), an S corp’s profit allocated to shareholders via K-1 is only subject to normal income tax, not self-employment tax. This can save owners the 15.3% self-employment tax that would otherwise apply to their business income. But there’s a catch: S corp shareholders who work in the business must pay themselves a reasonable salary as W-2 employees, which is subject to Social Security and Medicare taxes.

The IRS and courts have penalized S corp owners who try to avoid this rule by taking little or no salary while taking large K-1 distributions. For example, in a well-known court case (David E. Watson, P.C. v. U.S.), an accountant who paid himself only $24,000 in salary while his S corp earned over $200,000 in profits had most of his K-1 distributions reclassified as wages, resulting in additional tax and penalties. The lesson: enjoy the self-employment tax savings of S corporation distributions, but don’t abuse it – always pay yourself a reasonable wage for the work you do.

Losses and Stock Basis Limitations

S corporations, like partnerships, can pass through losses and deductions to their owners, but there are strict limits. You can deduct S corp losses only up to the amount of your stock basis (plus any direct loans you made to the company, giving you debt basis). Your stock basis starts with your capital contributions or purchase price for the shares, then increases by any income reported on your K-1 (and additional contributions), and decreases by any losses and distributions. If the S corp allocates a loss to you that exceeds your combined stock and debt basis, the excess loss is suspended – you can’t deduct it until you later increase your basis (for instance, via future profits or putting in more money). The at-risk and passive activity loss rules also apply to S corp losses similarly to partnership losses. Even with basis, you must be financially at risk for the investment (no guarantees protecting you from loss), and passive investors can only use passive losses against passive income.

S Corp Distributions: Typically Tax-Free (Up to Basis)

Aside from salary, S corporation owners often take money out of the company as shareholder distributions. A big benefit of S corps is that these distributions are generally not taxed to the shareholder when received, as long as they do not exceed your basis in the stock. This is because you’ve already been taxed on the company’s profits via the K-1 allocations. In effect, S corp distributions are usually just a return of previously taxed earnings or a return of capital. They will reduce your stock basis but won’t trigger immediate tax as long as basis is sufficient.

If you take out more in distributions than your basis, the excess is treated as a taxable capital gain (just like with partnership distributions). Also be aware: if an S corporation has accumulated earnings and profits (E&P) from earlier years as a C corporation (prior to electing S status), then distributions can be taxable as dividends to the extent of that old E&P once you’ve exhausted the S corp’s own accumulated tax-paid earnings (tracked in an account called the AAA – Accumulated Adjustments Account). In most small S corporations with no C-corp history, this isn’t a concern – distributions up to basis are tax-free.

Example: S Corp Owner’s K-1 and Distribution

Consider an S corporation that earns $150,000 in profit before paying its owner a salary. If you, as the owner-shareholder, take a salary of $70,000, that will be reported on a W-2 and taxed as ordinary wage income (with payroll taxes withheld). The remaining $80,000 of profit flows through to you via the K-1. You will pay income tax on that $80,000 when you file your Form 1040, but you won’t owe self-employment tax on it. Now say the company also pays you an $80,000 cash distribution during the year (to provide cash for your tax bill or personal use). That distribution itself is not taxed when you receive it, because it’s a withdrawal of profit that was already taxed via the K-1. Your stock basis would decrease by $80,000 due to the distribution. If you had no other basis beyond that year’s income, your basis would drop to $0, but you still owe no extra tax on the distribution. If instead the company distributed, for example, $90,000 and you didn’t have prior basis to cover the extra $10,000, that $10,000 portion would be taxable to you as a capital gain. This example shows how an S corp lets owners avoid double taxation on most profits, as long as you follow the rules.

Trust and Estate K-1s – Tax Rules (and Surprises) for Beneficiaries

How Trust K-1 Income is Taxed to Beneficiaries

If you receive a Schedule K-1 (Form 1041) from an estate or trust, it means you were a beneficiary who received taxable income from that entity. Trusts and estates, like business entities, can also be “pass-through” in the sense that they may pass taxable income out to beneficiaries. However, they operate a bit differently: a trust or estate itself can pay income tax (on income it retains), but it gets a deduction for any income it distributes to beneficiaries. The distributed income shows up on the beneficiaries’ K-1s, and the beneficiaries then report that income on their own tax returns.

In practice, this means if a trust earns income and then distributes that income to you, you – not the trust – will typically pay the tax on it. If the trust doesn’t distribute certain income, the trust will pay the tax itself (often at very high trust tax rates). The IRS sets very compressed tax brackets for trusts and estates, reaching the top 37% tax rate at around $14,000 of trust income, whereas an individual might need hundreds of thousands of dollars of income to hit the top bracket. This difference often creates a tax incentive for trusts to distribute income to beneficiaries (who may be in lower tax brackets) rather than retaining income and paying tax within the trust.

Simple Trusts vs. Complex Trusts (Distribution Requirements)

Trusts come in different varieties with different distribution requirements:

• Simple Trust: A simple trust is required to distribute all of its income to beneficiaries each year and cannot accumulate income. For example, if a simple trust earns $10,000 of interest and dividends this year, it must pay that entire $10,000 out to the beneficiaries. The beneficiaries will receive K-1s for that $10,000 and pay the tax, while the trust itself pays no tax on it (because it distributed the income). Simple trusts also generally cannot distribute principal (corpus) – only current income.

• Complex Trust: A complex trust may either accumulate income or make discretionary distributions; it isn’t required to distribute all income every year. It can also distribute principal. Any income that a complex trust does distribute carries out to beneficiaries via K-1 (taxable to them, with a corresponding deduction for the trust). Any income the trust retains is taxed to the trust. For example, a complex trust might earn $50,000 in a year, distribute $30,000 to beneficiaries, and retain $20,000. In that case, the beneficiaries’ K-1s collectively would report $30,000 (taxable to them), and the trust would pay tax on the $20,000 it kept. Estates (during the probate process) work similarly to complex trusts – they may or may not distribute income in a given year, and use K-1s to report any income passed out to heirs.

One special rule: in the final year of a trust or estate (when it’s terminating and distributing all assets), any remaining deductions or capital loss carryovers can be passed out to beneficiaries on the final Schedule K-1. This can be a nice last tax benefit to the beneficiaries.

Character of Income and Tax-Exempt Items

Income passed through to you on a trust or estate K-1 retains the same character it had in the trust. That means if a trust’s income includes qualified dividends or long-term capital gains and those are distributed to you, you’ll usually get the benefit of lower tax rates on those types of income. Similarly, if a trust earned tax-exempt interest (for example, from municipal bonds) and distributed it, your K-1 will show that interest as tax-exempt income – which you report, but which isn’t subject to federal tax.

Not all types of income are necessarily distributed to beneficiaries – for instance, many trusts keep capital gains as part of the principal and do not distribute them annually. If a gain isn’t distributed, it doesn’t appear on the beneficiary’s K-1 because the trust will pay the capital gains tax itself; the trust’s governing document and tax elections determine which items get passed out to beneficiaries.

Example: Trust Distribution vs. Retention

Suppose a testamentary trust (created by a will) earns $30,000 of interest and dividends, plus $20,000 of long-term capital gains in a year. The trust’s terms classify capital gains as part of the principal (corpus) that generally isn’t required to be distributed. The trustee distributes the $30,000 of interest and dividends to the trust’s beneficiary, Alice, but retains the $20,000 of capital gain inside the trust. Alice will receive a K-1 showing $30,000 of taxable income (interest and dividends) for the year, which she will report on her own tax return and pay tax on at her rates (ordinary rates for the interest, and preferential rates for the qualified dividends).

The $20,000 of capital gain was not distributed, so it does not appear on Alice’s K-1 – instead, the trust itself will pay the capital gains tax on that $20,000. Because the trust in this example distributed only part of its income, it will get a tax deduction for the $30,000 distribution, but still owes tax on the undistributed $20,000. If the trust had instead distributed the capital gains to Alice as well (which some complex trusts may elect to do), then Alice’s K-1 would have included the $20,000 capital gain, and she would pay the tax on it (likely at the 15% capital gains rate in her bracket). This example shows how a trust can shift tax liability to a beneficiary via the K-1 for distributed income, but any income not shifted will be taxed to the trust directly.

State Tax on K-1 Income – Don’t Get Double-Taxed

K-1 income may also be subject to state income taxes, which can get tricky if the business or trust operates in a different state from where you live. Generally, your home state will tax all of your income (including income passed through on K-1s), and the state where the income was earned will also want to tax it. To prevent true double taxation, states have credit mechanisms and special rules:

• Resident vs. Nonresident Taxation: If you live in State A but have K-1 income from State B (for example, you’re a partner in a partnership that does business in State B), you typically must file a nonresident tax return in State B to report the income earned there. State B will tax that income at its state tax rate. Meanwhile, State A (your resident state) will also include that K-1 income in your taxable income, but it will usually allow you to claim a tax credit for the taxes you paid to State B. This way, you pay at least the higher of the two states’ tax rates, but you don’t pay tax twice on the same income.

• State K-1 Forms: Many states require their own version of Schedule K-1 (or a similar schedule) when you file a state return. The partnership or S corp might issue a state K-1 reflecting your share of state-source income, which may differ slightly from the federal amounts due to different state tax rules (for instance, states might not conform to certain federal deductions or bonus depreciation).

• Withholding and Composite Returns: Some states simplify this by requiring the pass-through entity to withhold a percentage of income for nonresident owners, or by allowing a composite return filing on behalf of nonresidents. For example, a partnership in State B might withhold 5% of a nonresident partner’s share and remit it to State B’s tax authority as a prepayment of that partner’s tax. The partner can then claim that amount as a credit on their State B nonresident return. In a composite return, the partnership pays the tax for all nonresident partners in one combined filing, so those partners don’t file individual nonresident returns (usually they must consent to this arrangement).

• No State Income Tax Situations: If either your home state or the source state has no income tax (e.g., Florida, Texas, etc.), that obviously simplifies matters. You either won’t owe tax in that state, or won’t need a credit because one state isn’t taxing that income. Always check the specific state rules involved, as each state can have unique pass-through taxation quirks.

Example (Multi-State K-1): Jane is a California resident who owns 50% of an S corporation operating in Oregon. In one year, her K-1 reports $100,000 of business income sourced to Oregon. Oregon requires her to file a nonresident return and pay Oregon income tax on that $100,000. California will also tax the $100,000 as part of Jane’s income, but it will allow her to claim a credit for the Oregon tax paid. Thus, she effectively pays the higher of the two states’ tax rates on that income, avoiding double taxation on the same dollars.

The key point is that receiving a K-1 can mean tax obligations in multiple states, so it’s important to stay on top of both your resident state’s and the source state’s rules.

Common Mistakes with K-1 Income – Costly Errors to Avoid

Even experienced taxpayers can slip up when dealing with K-1s. Here are some frequent mistakes to watch out for:

• Failing to report K-1 income – Forgetting to include the numbers from a K-1 on your tax return can lead to IRS notices and penalties (the IRS gets a copy of every K-1, so they will know if you omit it). Always double-check that you report all K-1 income, even if no tax was withheld.

• Assuming “no cash, no tax” – Don’t assume that just because you didn’t receive a cash distribution, you don’t owe tax. Many people are caught off guard by phantom income from partnerships or S corps. Remember, you must pay tax on your share of earnings reported on the K-1 whether or not you actually got the money.

• Mixing up distributions and income – People often confuse the K-1 allocation with the actual distributions they received. Remember, the income on the K-1 is what’s taxable, not necessarily the cash you took out. A large distribution might be tax-free if it was from previously taxed earnings, while a large taxable income can occur with little or no cash distributed.

• Deducting disallowed losses – Be careful with losses shown on a K-1. You can’t automatically deduct a K-1 loss against other income. First ensure you have enough basis and are at risk for the investment. Also make sure you materially participated if you want to use the loss against non-passive income. Deducting losses without meeting these rules can trigger disallowed deductions and IRS adjustments.

• Not taking a required S corp salary – S corporation owner-shareholders sometimes try to skip paying themselves a wage to avoid payroll taxes. This is a mistake that can draw IRS scrutiny. Always pay yourself a reasonable salary from an S corp (in addition to taking K-1 profits), or you risk penalties and back taxes for unreported employment taxes.

• Ignoring state tax obligations – A common error is overlooking state tax filing requirements for K-1 income from out-of-state entities. If you get a K-1 from a partnership or S corp operating in another state, you may need to file a nonresident return or pay state taxes there. Failing to do so can result in state tax penalties down the road.

• Missing the QBI deduction – Income from many partnerships and S corps qualifies for the 20% Qualified Business Income (QBI) deduction under Section 199A. However, you must actively claim it on your tax return. The K-1 will have codes indicating if your income is eligible. Overlooking this deduction means paying more tax than necessary.

• Poor basis tracking – Not keeping track of your basis in a partnership or S corp can lead to mistakes. For example, you might accidentally claim a loss deduction or take a cash distribution that exceeds your basis, leading to an unexpected taxable gain or disallowed loss. Maintain records of your capital account, contributions, distributions, and allocated income each year so you know your basis before claiming deductions or taking distributions.

• Filing before receiving all K-1s – K-1s are often issued later than W-2s or 1099s. Rushing to file your tax return without waiting for a K-1 (or at least an estimate of it) can be problematic. If a K-1 arrives after you file, you’ll likely have to amend your return to include that income. It’s usually better to extend your tax return filing if you’re still missing K-1s.

Pros and Cons of K-1 Pass-Through Taxation

Frequently Asked Questions (FAQs)

Q: Do I have to pay tax on income reported on a K-1?
A: Yes. Income reported on a K-1 is generally taxable to you at your applicable tax rates, even if you didn’t actually receive a cash distribution of that income.

Q: Are K-1 distributions taxable?
A: Usually not. Cash distributions from a partnership or S corp are typically not taxed if they don’t exceed your basis, because the income was already taxed via the K-1.

Q: Is K-1 income considered earned income?
A: Generally no. K-1 income is usually considered passive or investment income, not wage income. It typically doesn’t count as “earned income” for purposes like IRA contributions or the Earned Income Credit.

Q: Do I need to attach the K-1 form to my tax return?
A: Not when e-filing (the data is sent electronically to the IRS). If you mail a paper return, attach a copy of each K-1. Always keep your K-1 forms with your records.

Q: What if I get a K-1 after I already filed my taxes?
A: You’ll likely need to file an amended return (Form 1040-X) to include the K-1 information, unless the amounts are negligible. It’s best to wait for all K-1s before filing.

Q: Do I pay self-employment tax on K-1 income?
A: It depends on the entity type. Partnership business income usually incurs self-employment tax if you’re an active partner. S corporation K-1 income isn’t subject to self-employment tax (only W-2 salary is).

Q: Can I use a K-1 loss to reduce my other income?
A: Possibly, but only if you meet certain conditions. You need sufficient basis and at-risk investment, and the loss can’t be passive (unless you have other passive income to offset it).

Q: Why did I receive a K-1 instead of a 1099?
A: Because you’re an owner (partner, shareholder, or beneficiary) of a pass-through entity. A K-1 reports your share of the income, whereas a 1099 is for income from someone else’s business (interest, dividends, etc.).

Q: Can K-1 income qualify for the 20% QBI deduction?
A: Yes, if it’s from an eligible trade or business (not just investment income or disallowed service income) and your taxable income is within the limits. Check your K-1 for Section 199A info.

Q: Does K-1 income trigger the 3.8% Net Investment Income Tax (NIIT)?
A: It can. Passive income from K-1s (for example, rental income or limited partnership income) is subject to the NIIT if you’re above the income threshold. Active business K-1 income is generally exempt from NIIT.

Q: When should I expect to receive my Schedule K-1?
A: Typically by March 15 for calendar-year partnerships and S corps (the due date of their entity tax return). If the entity files an extension, the K-1 might not arrive until mid-September.