October 21, 2015

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Alisha asks:

I have a customer who has multiple K-1’s listed on his tax return. He did not have a single one attached to his return so I asked for all of them. He is stating that several of them are investments and he did not receive a K-1. Is that possible?

Linda says:

With global cash flow analysis of tax returns, the lender needs to acquire all the relevant schedules. For most of you, all of the K-1s are on the list. But lenders everywhere tell me that getting the K-1s from their borrowers is like pulling teeth.

I never have quite understood this except to say that some of what shows up on their returns is a mystery to them and they do not want to ask their CPA or tax preparer because it will cost them money. So saying to you they do not have it is easy to do and maybe you will back off. But there are other reasons they might make this statement, and believe it.

K-1s as attachments

First, the K-1 is not an attachment to the 1040 so you will never find them attached to the return. The K-1 is to the 1040 just like a 1099 is to a 1040. You get the 1099 from your bank and use the information provided to enter interest on your 1040 Schedule B.

When you find entries for pass-through entities (S-Corporations, Partnerships of any kind or LLCs filing either of those returns) on the back-side of the 1040 Schedule E, you will have to ask for the K-1s if you want them.

Is it possible the borrower did not receive the K-1s?

It depends on what you mean by “receive”. Understand that the K-1 does exist, in some form, or the return of the partner/shareholder could not have been prepared. That said, the taxpayer may have elected to receive the K-1 electronically. And the information from that digital K-1 may have been extracted by their tax preparer. Thus, they are telling you the truth when they say they do not have a (paper) K-1. But, they can get it.

The K-1s might not look like K-1s

The IRS allows partnership, S corporations and LLCs filing one of those forms to issue ‘substitute’ K-1s. They have to have these substitutes approved by the IRS if they do not look substantially like the standard K-1.

So, if your borrower gives you something that does not look right, look a bit closer. The substitute K-1s are very common with investment pass-through entities. Here is what they must contain, somewhere on the page:

  • Name, address, and SSN or EIN of both the entity and recipient.
  • The tax year, the OMB number, the schedule number (K-1), the related form number (1041, 1065, 1065-B, or 1120S), and the official schedule name in substantially the same position and format as shown on the official IRS schedule.
  • All applicable amounts and information required to be reported, and titled and numbered in the same manner as shown on the official IRS schedule.
  • All items required for use by the recipient. The instructions to the schedule must identify the line or box number and code, if any, for each item as shown in the official IRS schedule.
  • The amount of each recipient’s share of each item must be shown.
  • Instructions to the recipient that are substantially similar to those on or accompanying the official IRS schedule
  • State or local tax-related information may be included on recipient copies of substitute Schedules K-1.
  • The legend “Important Tax Return Document Enclosed” must appear in a bold and conspicuous manner on the outside of the envelope that contains the substitute recipient copy of Schedule K-1

So, where are they?

Whoever prepared his return has the pile of K-1s, nice and neat, in their folder, digitally or printed. The tax return could not have been prepared without them.

Do you really need them?

This borrower asserted that some of the K-1s were from investments. Whether the K-1 information is listed in a passive or a non-passive column gives you valuable information.

If on the passive side, the taxpayer is not actively involved in the management and decision-making of the entity. This is where you will find investments. When I provide internal training for financial institutions, I train to their guidelines and use their worksheets or software. I have seen a significant variety in guidelines regarding how to treat pass-through entities. Some of my banking clients do not require every K-1. In those cases, they might skip K-1s if they are reported on the passive side and are not material in amount.

I do not know your guidelines but it is worth checking. The idea, in this case, is that the cash flow from investment pass-through entities is not something you want to count on or is not material during the investment phase. Be aware, though, that some investments may have call provisions and this borrower may have an obligation to contribute more capital, if needed by the entity.

Are pass-through entities and K-1s a mystery to you?

Admittedly, these are the posts that get the most readers. If you need to improve your overall understanding of the pass-through entites, K-1s and passive vs non-passive, here are a few of our online modules that are on point.

Join our virtual class on Global Analysis of Tax Returns

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.