Tax complexities of partner reporting

1. No structure 

Although it is clear that partnerships are required by statute to provide partners with the information necessary to compute their distributive share of partnership income and deductions from any trade or business, there are no real guidelines as to how that information should be reported. The old adage “If you’ve seen one, you’ve seen them all” couldn’t ring more falsely than in the context of a K-1. For those of us who work with a great deal of K-1 packets, the opposite is true – “If you’ve seen one K-1, you’ve seen one K-1.” Unlike nearly every other tax form, the K-1 has almost no structured format beyond the general demographic information. Even if you look at the K-1 Lines 1-20, it may seem pretty straightforward until you refer to page 2 that outlines the more than 200 data elements that a K-1 recipient may need in order to calculate federal taxable income. The Internal Revenue Service (IRS) even had to restart the alphabet for Line 20 to account for all the data to be reported on a single line. And that’s just federal. Adding state and international filing requirements, which have no required structure, means a lot of time spent pouring over a K-1 packet to make sure you’ve captured everything you need, for today and tomorrow’s reporting requirements.

2. No consistency

IRS published statistics through the 2016 tax year that show approximately 3.7 million partnerships with more than 28 million partners. Adding K-1s from S Corporations and Trusts, there are more than 40 million K-1s produced each year. It’s remarkable that while the data needed in a K-1 is fairly prescribed, the way in which this information is reported varies widely. Even K-1 packets received from the same tax preparers could be materially different in the format used and the details provided. Some reasons for this could be tiered partnership structures, specific partnership preference, and the time crunch usually experienced by tax preparers who often receive the last bit of information and need to distribute the next batch of K-1s within a day, if not hours.

3. Different audiences, same packet

We discussed the lack of structure and consistency of Schedule K-1 packets, but what might be even more frustrating is the receipt of an identical K-1 packet even though the data needed for each recipient varies widely. A partnership’s K-1 packet will often be identical regardless of whether the investor recipient is an individual, trust, tax exempt organization, corporation or partnership. A tax-exempt organization is going to need information to determine if there is unrelated business taxable income while an individual will look for passive activity guidance, at-risk limitations, and ordinary income characterizations. While you might hope that the preparer of that K-1 packet is knowledgeable in each area of the law for each legal entity type, it’s not likely. All the more reason to have a complete list of everything you need to know so that you can properly assess your K-1 packet and request more information if necessary.

4. CPA and the tiered partnership

Those of us who worked so hard to obtain the Certified Public Accountant (CPA) credential will certainly cringe when we hear the blasphemous “cut, paste, and assemble” analogy. The complexities of partnership reporting, the tiered partnership structure, and the necessity to turn tax data up to the next tier doesn’t allow much time to decipher the information received and aggregate with current operational activities for federal, state, and international purposes. Not to make excuses for the profession, but the graphic below from the U.S. Government Accountability Office (GAO) highlights the issue. When complex tiered partnerships are combined with a reporting requirement with no required format or structure, the result is chaos. What’s interesting about this example is that as complex as it looks, it has only 50 partners and 10 tiers. Large partnership structures could be much more complex. Some large partnerships have more than a million partners and some others have more than 50 tiers.

Example of Partnership Structure

The Four Dimensions of K-1 Reporting

While few people will think of a K-1 as analogous to a fourth dimension of space, the 4D concept helps to explain the pain and complexity of K-1 aggregation quite well.

To explain: Point has zero dimensions. It has no width, depth or height. You could say that a single data element (Line 1 ordinary income) has zero dimensions.

Now let’s think about the first dimension – height. If you draw a line from Line 1 at the top of a K-1 down to the bottom of Line 20, then include all other 200 elements listed in the instructions, you’ve got to your first dimension. It’s a long line, but a line nonetheless. However, if you compare the line of a Schedule K-1 to, let’s say, a Form W-2, there is no comparison. The Form W-2 is structured, formatted, and generally means the same thing to each recipient. And that’s just the federal. Gathering the allocation or apportionment data for each state and foreign ownership and international transfers, a preparer is probably aggregating about a thousand data elements for each K-1. That gets to be a very long line. The issue is compounded when you think about the second dimension of a K-1 – width.

The width of a K-1 is added when we start to take each line item from the first dimension and relate that to the recipient’s entity type. From a federal perspective, every single data point provided (all 200) needs to be analyzed by wearing the hat of that particular legal entity. Unfortunately for the investors, though, is that often the K-1 preparer may not understand exactly the information needed by the end K-1 recipient. Often preparers punt and suggest “consult your tax adviser” or provide a “you may have” caveat in the K-1 footnotes of how to address the information listed. The example below highlights just a few of the federal tax issues that are present in the reporting of Line 1, Ordinary Income, depending on the legal entity type of the investor. 

Stack your K-1s into a pile and you’ve hit your third dimension – depth. If you only receive one or two Schedules K-1, you can probably feel pretty comfortable that you’re able to aggregate and assess for all the risk areas, especially if the partnership activities are in the U.S. and the operations are performed in only a handful of states. But if you’re aggregating and analyzing a stack of K-1s, it is difficult for the human brain and even a tool like Microsoft Excel to capture all the necessary data elements and provide the analytics necessary to assess for federal, state, and international filing requirements.

If you share stories or best practices with other tax preparers, you’d likely hear that, because of the K-1 volume and lack of time, a reviewer will scan each K-1 individually and make a determination at the single K-1 level of whether it’s even worth keying that information into an analysis. To conduct this type of review means taking on a lot of unnecessary risk. Materiality is not a tax concept. Generally, international disclosures are required when there’s a cash transfer of $100,000 or more outside the U.S. This threshold is not at the individual K-1 level but at the individual investor level, and is aggregated over a rolling 12-month period and combined with transfers from other partnership interests. For non-cash transfers, there is no dollar threshold for reporting. States also have, among other things, filing thresholds based on either apportioned or allocated state income. We won’t have time in this article to address all the limitations or thresholds for federal purposes.

Our fourth dimension happens when you’re spanning time. If you take the first three dimensions described above:

1. A thousand data elements – height,
2. Different treatment based on recipient entity type – width and,
3. Aggregating a stack of K-1s into one analysis – depth,

you’ll then add this analysis to your prior year amounts in order to carry forward all information to plan for next and future years.

So often K-1 recipients are bogged down in the aggregation and tax preparation on an annual basis that it’s difficult to save time for planning for future transactions regarding their investments. But this is so important. We often see large investors leave basis tracking until they’re selling an asset. It’s just one more thing that resource-constrained tax departments don’t have time for. But if you think about it, the partnership investment will be sold. That’s its purpose. Many investment partnerships have 10- to 15-year shelf lives so leaving the basis tracking to a later day will mean digging into lots of old files, assuming this information is even available. It’s important to keep current with this information.

State filings is another area where time may change your answer. In the early stages of a partnership, there may not be enough state income to warrant a state filing responsibility. However, increased income or the sale of an asset or the partnership interest itself could give rise to a sudden income spike in a given state. It’s important to think about whether not filing a state return when there are losses jeopardizes your ability to maintain and preserve your net operating loss to carry forward for future years.

Complexities in state filing requirements warrants its own discussion. Please read further in our next article in the series, “State Complexities in K-1 Aggregation.”