If you are an angel investor, there are chances that you have seen a K-1 before. If you are new to angel investing, the Schedule K-1 is a document you will need to familiarize yourself with due to tax reasons.
The Schedule K-1 can be confusing, so we are taking the time to detail what it is, who it is for, and how to interpret it.
This is for informational purposes only. Propel(x) does not provide tax advice of any kind. Investors should consult their personal tax advisor for all tax related issues.
Tax codes in the United States allow several different entity types to use ‘pass-through taxation’. This means that the entity is not taxed. Instead, any profits or losses are ‘passed through’ to members / partners of the entity and these members / partners pay their prorated share of the income tax liability.
This is relevant for Angel Investing because the SPV, or Special Purpose Vehicle, has become an integral part of angel investing, bringing down the investment amount needed and making it possible for ordinary investors to participate. The Schedule K-1 is required to report profits and losses for entities like these. If you invest via a Syndicate, a.k.a. SPV, you should receive a K-1 from your syndicate. If the SPV earned a profit, you will be liable for your prorated share of the income tax. Or, you may get a potential tax break if your syndicate incurs a loss. Because investors are participating in a new SPV each time they invest, this means organizing and managing your K-1 information is more important than ever before. As we suggest that you consult with your tax advisor.
At Propel(x), our subsidiary Planck Fund Management Corporation (PFMC) manages all syndicates created on the platform. Because this is a wholly owned subsidiary, we have complete visibility into syndicate ownership details at any given time. We also stay in touch with the issuers (startups) to try and get regular updates that are shared with investors.
What makes our set-up very convenient for investors, is that all K1s are distributed via the “My Account” section on the Propel(x) website. Since K1s are distributed via our secure website, investors’s information remains protected and safe.
Finally, PFMC earns a carried interest on the profits generated when the syndicates have an exit. So our interests are very much aligned with our users’. We work very hard to stay on top of future funding rounds and try to make sure that all of our users are able to get their pro-rata investment opportunity and that the terms are as best as we can secure for our syndicate members.
This type of investment is illiquid and there is no guarantee that an exit strategy will come to pass. You may not ever be able to sell or liquidate the investment or to receive a return of principal.
Type of K-1s
There are three different IRS tax forms, which include a schedule K-1.
Form 1041 is used by trusts and estates to file their taxes. If a trust or an estate passes income through to the beneficiaries, these beneficiaries will receive a K-1 and will be required to report it. The trust or estate will then report a deduction for the same amount. This prevents the IRS from taxing the income twice.
S-corporations must also file annual tax returns, much like a partnership. The form they use is an 1120S. The S-corporation is required to provide the schedule K-1 associated with this tax form to each shareholder, reporting its income, losses, deductions, and credits. The shareholders can then report this same information on their individual tax returns.
Form 1065 is the only tax form that is relevant to our discussion. This is the form used by SPVs (typically LLCs) to file their taxes. The SPV files a Form 1065 and sends a copy of the Schedule K-1 to each individual member. Each individual member then uses this schedule K-1 to report their share of the income, credits, or deductions.
Who Files a K-1?
Anyone who invests in a pass through entity or is a part of a partnership will receive a Schedule K-1 that must then be used to report their share of income or losses. That includes individuals who have invested in:
- General partnerships
- Limited partnerships
- Limited liability partnerships
- Limited liability companies choosing to be taxed as a partnership
If you are not sure that this is you, there are a few ways you can tell. You have signed a partnership agreement and registered the partnership with the state OR you co-own a business with one or more other people but the business is not incorporated OR your company is an LLC not taxed as a corporation.
For angel investors, you will know if you are a member of a partnership because you have made investments through an SPV registered as an LLC.
Why Do You Need a K-1?
It is critical that any of the above people receive a Schedule K-1 from any SPV they invested in as part of their annual taxes. Including any Schedule K-1s keeps your taxes up to date and helps you to avoid potential tax penalties.
When are K-1s Due?
For entities such as partnerships and LLCs, the Form 1065 is due March 15 unless an extension is filed. Because March 15 is also the deadline for partnerships to issue K-1s to the members of an LLC or partners of the partnership, it gives partners about a month to file their personal returns.
Calculating partner shares of income can be very complex and time consuming, so many investors struggle to get their K-1s on time. You can file for a 6-month extension using Form 7006.
How Can You Report Income From a Schedule K-1?
Reporting income on the Schedule K-1 is relatively simple. It involves knowing how to read the K-1 document and filling it out correctly. If you are not familiar with how to read your schedule K-1, we will review that here.
How to Read a K-1
This sample Schedule K-1 can be found on the IRS website. Reading it proves difficult for some, so here is a detailed account of what it includes.
Part I – Information about the partnership
This section includes information about the partnership.
This is for the partnership’s Employer Identification Number (EIN). This is not the individual partner’s SSN.
This is for partnership contact information.
This is where you enter the IRS filing center you’re sending the Form 1065 to.
Check this box for publicly traded partnerships (PTP) with shares bought and sold on an established securities market.
Part II – Information about the partner
This section is dedicated to information about each individual partner.
Your Taxpayer Identification Number (TIN) is either your social security number, your individual taxpayer identification number, or your employer identification number, if you invested through a trust or a personal entity.
This section includes partner contact information and status as well as whether you’re a foreign or domestic partner.
This is where you report your share of profits, losses, and capital. These amounts are based on the business’s partnership agreement. For partners who entered the partnership after the beginning of the reporting period, the percentage that applied when they entered belongs in the Beginning column. For partners leaving the partnership before the end of the reporting period, the percentages that applied when they left belong in the Ending column.
This section is for the partner’s share of the partnership’s liabilities. These are sorted by type. Recourse debt holds the borrower personally liable, which means a lender can come after personal property. All other debt is considered non recourse.
This is how much capital you had in the business at the beginning of the reporting period, how much you put in throughout the year, if your share increased or decreased, withdrawals or distributions made, and how much capital you had at the end of the reporting period.
The IRS indicates that a built-in gain or loss is the difference between the fair market value of the item and your adjusted basis in the property at the time it was contributed to the partnership. Check Yes here if you contributed any property with a built-in gain or loss.
Part III – Partner’s share of current year income, deductions, credits, and other items
Use this section to report your share of the partnership’s income, loss, deductions, credits, or any other money you received due to your stake in the partnership. Use the codes on page two of Form 1065 to fill out boxes 11 and 13-20.
Box 1 – Ordinary Business Income (loss)
Your share of the ordinary income from business or trade activities goes here.
Box 2 – Net Rental Real Estate Income (loss)
Your share of net rental real estate income from the partnership goes here. This includes renting housing, retail space, office space, or any other real estate.
Box 3 – Other Net Rental Income (loss)
Enter your share of any other rental income from the partnership here.
Box 4 – Guaranteed Payments
If you receive guaranteed payments from the partnership, that goes here. These are payments the partnership makes to you no matter whether the partnership earns income. It’s typically in exchange for services or the use of capital.
Box 5 – Interest Income
Report any interest income here. This includes bonds, bank accounts, and certificates of deposit.
Box 6 – Dividends
Record any ordinary, qualified, and dividend-equivalent payments from the partnership here.
Box 7 – Royalties
Report any royalties you received from the partnership here.
Box 8 – Net Short-Term Capital Gain (loss)
Report short-term capital gains or losses here.
Box 9a-c – Other Capital Gains (losses)
This section is for long-term gains or losses you sustained from the partnership this year.
Box 10 – Net Section 1231 Gain (loss)
The sale or exchange of property, cattle and horses, leaseholds, timber, iron ore, coal, and other property are Section 1231 transactions. Record these here.
Box 11 – Other Income (loss)
Anything that doesn’t fall into the interest, ordinary dividends, royalties, or capital gains categories are reported here.
Box 12 – Section 179 Deduction
Claim your share of Section 179 deductions here.
Box 13 – Other Deductions
Use the codes on page two of Form 1065 to report other deductions here. That includes cash contributions, noncash contributions, educational assistance benefits, and pensions and IRAs.
Box 14 – Self-Employment Earnings (loss)
Report self-employment earnings or losses here.
Box 15 – Credits
Use the codes on page two to report the credits you’re claiming. This includes low-income housing credits, disabled access credit, work opportunity credit, or research activities credits.
Box 16 – Foreign Transactions
This section is used to report your share of income or losses for doing business overseas.
Box 17 – Alternative Minimum Tax (AMT) Items
Information applicable to you regarding AMT information is entered here.
Box 18 – Tax-Exempt Income and Nondeductible Expenses
Any tax-exempt income or nondeductible expenses are reported here.
Box 19 – Distributions
Report any distributions you receive in the form of property, marketable securities, or cash here.
Box 20 – Other Information
This is where you report any other information using the codes on page two.
The Impact on Convertible Note Investments
K-1s are particularly important for any convertible note investments you have made. Most convertible notes accrue interest, but do not pay it out to investors. Investors however, are liable to pay their share of taxes on accrued interest as reported on their Schedule K-1s. This is important to realize, as investors can be stuck with a tax bill when their investment may be going under.
For investments in companies that fail or convertible notes that never convert, the SPV will eventually report a loss that you can use to write off or deduct the taxes you have already paid on the investment you lost.
K-1s are critical for angel investors who are investing through entities like SPVs. While not every part of the document will apply to an individual investor, it is important that you know why it is used and how to read it.
If you have ever invested through an SPV, you have likely seen this document many times. If you plan to invest via an SPV in the future, we encourage you to familiarize yourself with the Schedule K-1 now and expect to receive one during tax season.
This post is for informational purposes only. Propel(x) does not provide tax advice of any kind. Investors should consult their personal tax advisor for all tax related issues.
This post contains links to third-party websites. These links are provided solely as a convenience to you and do not imply an affiliation, sponsorship, endorsement, approval, investigation, verification, or monitoring by us of the contents on such third-party websites. We are not responsible for the content of any website owned by a third party and do not guarantee the accuracy, timeliness, completeness, suitability, reliability, or usefulness of any information.
Private Placements are a high-risk investment. An investment in this offering is speculative and an investor could experience an entire loss of principal. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that an investment will be profitable or that there will ever be an exit strategy or an opportunity to liquidate the investment. Investments in early-stage private companies should only be part of your overall investment portfolio.