Pass-through entities, such as LLCs and business partnerships, have become the most popular investment vehicles for both individuals and IRA accounts. The reason for this is a pass-through entity offers the owners “flow-through” tax treatment. In other words, the entity is not subject to an entity-level tax. Instead, the income, gains, and losses flow through to the members of the LLC without being subject to any entity-level federal income tax. This flow-through nature impacts the tax liability of individual stakeholders, as they must report the income on their personal tax returns.

By using a pass-through entity, an investor is essentially able to benefit from entity-level limited liability protection, like a corporation, but gain flow-through tax treatment. Schedule K-1 is the form that reports the amounts that are passed through to each party that has an interest in the entity taxed as a partnership.

What is a K-1 Form?

The K-1 or K-1 form, also known as a Schedule K-1, is a crucial tax document used to report an individual’s share of income, deductions, credits, and other tax items from partnerships, S corporations, or certain trusts and estates. These entities are considered “pass-through” for tax purposes, meaning they do not pay taxes at the entity level.

Instead, they distribute their taxable income and losses to their partners, shareholders, or beneficiaries. The recipients then include this information on their own tax returns, ensuring that the income is taxed at the individual level. This process helps prevent double taxation, as the income is not taxed at both the entity and individual levels.

Types of K-1 Forms

There are different types of K-1 forms, each serving a specific purpose based on the type of entity:

• Partnerships: Schedule K-1 Form 1065 is used to report each partner’s share of the partnership’s earnings, losses, deductions, and credits. This form ensures that the partnership’s income is passed through to the partners and reported on their personal income tax returns.
• S-Corporations: Schedule K-1 Form 1120-S is used to report each shareholder’s share of the corporation’s income, losses, deductions, and credits. This form allows S corporations to pass their income directly to shareholders, who then report it on their personal tax returns.
• Trusts and Estates: Schedule K-1 Form 1041 is used to report income distributed to beneficiaries. This form ensures that the income from trusts and estates is passed through to the beneficiaries and included in their personal tax returns.

Who Generates and Files a K-1 Form?

K-1 forms are generated by pass-through entities, including partnerships, S corporations, trusts, and estates. These entities complete the appropriate K-1 form and provide it to their partners, shareholders, or beneficiaries. The recipients then use the information from the K-1 form when filing their personal tax returns. This process ensures that the income, deductions, and credits are accurately reported and taxed at the individual level, in line with the pass-through taxation principle.

Single Member LLC vs. Partnership

The member of a single-member limited liability company (“SMLLC”) will benefit from the limited liability associated with a limited liability company (“LLC”) as well as the benefit of a single level of tax and the flow-through of business losses.

For tax purposes, an SMLLC is treated as a sole proprietorship and will not require a separate federal income tax filing. The income tax can be reported on schedule C of the member’s personal income tax return (Form 1040).

For federal income tax purposes, an SMLLC is disregarded. Therefore, if an SMLLC is treated as a disregarded entity for federal income tax purposes, the income of the LLC is taxed to the owner directly, without any entity level tax. In addition, LLC losses would flow through to the member and the member could deduct his or her ratable share of the losses generated. The income and losses from an SMLLC are reported on the owner’s personal taxes, affecting their overall tax obligations and potential deductions.

A multi-member LLC can be either a partnership or a corporation, including an S corporation. A multiple-member LLC is an LLC that is owned by two or more members. It is treated, by default, as a partnership by the IRS.

IRS Form 1065 – Partnership Income Return

IRS Form 1065 is an information return used to report the income, gains, losses, deductions, credits, and other information from the operation of a partnership. Generally, a partnership doesn’t pay tax on its income but passes through any profits or losses to its partners. Partners must include partnership items on their tax or information returns. The partnership files a copy of Schedule K-1 (Form 1065) with the IRS to report your share of the partnership’s income, deductions, credits, etc.

The IRS defines a partnership as a relationship between two or more persons who join to carry on a trade or business, with each person contributing money, property, labor, or skill and each expecting to share in the profits and losses of the business whether or not a formal partnership agreement is made. However, a joint undertaking merely to share expenses isn’t a partnership if the co-owners do not provide any services to the tenants. Mere co-ownership of property that is maintained and leased or rented isn’t a partnership.

In general, every domestic partnership must file Form 1065, unless it neither receives income nor incurs any expenditures treated as deductions or credits for federal income tax purposes.

Multiple-Member Self-Directed IRA and Pass Through Taxation

The use of an LLC by IRA owners has become an increasing popular way to buy real estate and other alternative assets for a number of reasons. The ability to gain limited liability protection, privacy, and the opportunity to have more control over the investments are the primary reasons investors have elected to invest their IRA via an LLC to make an investment.

The following is a breakdown of how the Checkbook IRA (also known as a Self-Directed IRA LLC) works:

In general, in the case where the IRA is the sole owner of the LLC, the LLC is treated as a disregarded entity for federal income tax purposes and no federal income tax return is required to be filed.  However, if the LLC will be owned by two or more members, the LLC will be considered a partnership and IRS Form 1065 must be filed.

Form 1065 is required to be filed, or an extension requested, by March 15th each year.

IRS Form 1065  – Schedule K-1

The partnership uses Schedule K-1 to report your share of the partnership’s income, deductions, credits, etc. Schedule K-1 is part of the IRS Form 1065.  A copy of Schedule K-1 is sent to the IRS and a copy to each LLC member.  The LLC member will use the K-1 to report income or losses on his or tax return.  However, in the case of a Checkbook IRA, the IRA is tax-exempt and does not generally pay tax. Hence, the K-1 is simply sent to the IRA member but there is generally no tax consequence.

If your Checkbook IRA will be investing in a multiple-member LLC, the manager or general partner of that entity would be responsible for completing Form 1065 & Schedule K-1.  Whereas, in the case of a multiple-member Checkbook IRA, where the IRA owner is serving as the manager of the LLC, the IRA owner would be responsible for filing Form 1065/Schedule K-1.  Below are some keys tips to remember when completing Schedule K-1:

• Part I: Make sure to include the name and EIN of the LLC
• Part II: For partner’s info – please include the name of the IRA care of the IRA custodian.  For example, IRA Financial Trust Company FBO John Doe IRA.  You should also use the address of the IRA custodian.  Regarding the EIN of the IRA, you have an option of using the EIN of the IRA custodian or you can acquire an EIN on the IRS website. In addition, it is important to check box I2 that the partner of the LLC. The remaining portion of Part II should be completed based on the financial details of the LLC.
• Part III: Please complete based on the financial details of the LLC during the taxable year.  Note – if the LLC has ordinary business income to report in Box 1 above $1,000, the LLC could be subject to a tax known as the unrelated business taxable income tax or UBTI/UBIT.  In addition, UBTI can be reported on Schedule K-1 using Code V in Box 20.

Conclusion

Investing in a multiple-member LLC with a Checkbook IRA is quite common and is generally not subject to any tax. However, it is important to be aware that as the manager of the IRA, IRS Form 1065 and Schedule K-1 must be timely filed with the IRS. Part II of Schedule K-1 is the portion of the Schedule where you will indicate to the IRS that the member or partner of the LLC is a tax-exempt IRA.

If you have any questions about setting up a multiple-member LLC with a Checkbook IRA, contact our team of experts today.