I HATE K-1s!

While unlike Nick Bottom I don’t hate Shakespeare, I do hate K-1s.  Specifically, K-1s for limited partnership investments. 

First, they are never sent out to taxpayers until mid to late September – so taxpayers with these investments require a GDE (the E = extension).

But more important, the K-1 for limited partnership investments report many sources of “Other Income” and “Other Expenses” without clear instructions about where to report these items on the Form 1040.  It is confusing and a true PITA for both taxpayers and professional tax preparers.

For example - what is “portfolio income”?  A post from THE STREET explains -

“In a word, portfolio income is the totality of investment income in a single portfolio, including dividends, interest, and capital gains. In many cases, portfolio income also includes any money (in the form of royalties) from real estate investments.”

The K-1 has specific lines for reporting dividends, interest, capital gains, and royalties with explicit instructions as to where to put these numbers on the Form 1040.  But under “Other Income” there is often reported “Other Portfolio Income”.  Why is this “other” portfolio income identified separately and not included in the specific lines for portfolio income?  There is no clear instruction on where to report this income.

The items of Other Income and Other Expenses also refer to obscure Internal Revenue Code Sections 59(e), 743, 754, 965, 988, etc. and other obscure items - with no clear instructions on exactly where on the Form 1040 to report these items.  And the new K-3 for foreign tax items adds more complexity and confusion to an already confusing issue.

I have not come across anywhere any CPE seminars, workshops or classes or any books or publications dealing specifically with exactly where to put all K-1 items on the Form 1040.  NATP has provided an offering on preparing the K-2 and K-3 – but not on how to put K-3 items on the Form 1040.  In the past when print K-1 packages were sent via postal mail there occasionally was a “map” for 1040 reporting, but now most K-1s are received via pdf email attachment with no more such assistance. 

Before retiring, my response to this issue was to refuse to do tax returns for any taxpayer, any potential or current client, who had K-1s from limited partnership investments that report anything in Box 11 and Box 13.  Unfortunately, there was one client with over a dozen such K-1s that I could not refuse. 

Tax professional associations should include a seminar or class on this topic in their CPE offerings.  

Fellow tax pros - do you agree with me?  

TTFN

TALKING TAX REFORM - FIXING THE LIMITED PARTNERSHP K-1

It seems appropriate on Halloween to discuss one of the scariest items involved with 1040 preparation.

 

I have said it before and I will say it again.  I HATE K-1s.  Specifically, the K-1s, always late, for limited partnership investments.

 

In almost all cases, unless there is a substantial investment, the financial tax benefits of these type of investments, if there are any, are wiped out by the cost of the additional work to actually prepare the investor’s individual tax returns.

 

I very seriously believe that brokers receive a higher commission for selling these investments, and often brokerage houses instruct their brokers to sell specific limited partnership investments to clients.  I also firmly believe that there are alternative mutual fund investments that provide the same, or perhaps better, investment returns.

 

If all we had to deal with were items in boxes 1 through 10 and 12 – business income, interest, dividends, capital gains, and the Section 179 deduction – it would be ok.  The instructions on Page 2 of the Form K-1 clearly indicate what line on series 1040 forms and schedules on which to enter these numbers.  The problem with these GD forms concerns the items of “other income” and “other deductions”.

 

For example, under “other income” the referenced internal supplemental statements reference Internal Revenue Code Sections 475, 988, and 1256, cancellation of debt, other portfolio income, and other income (not specifically identified).  For most of these items the instructions say “See the Partner’s Instructions”. 

 

“Portfolio income” is interest, dividends, royalties, and capital gains.  Sometimes the “other income” boxes detail specifically references “interest, dividends, and capital gains”.  Why is this income not included in the boxes in the first 10 that specifically identify interest, dividends, royalties, and long and short-term capital gains?  Are these items reported on Form 1040 Schedules, B, D or E, or are they merely “other income” reported on Form 1040 Line 21?  Or do they go elsewhere?

 

“Other deductions” refers to Internal Revenue Code Sections 59(e)(2) and 743, pass-thru deductions, royalty deductions, and, again not specifically identified, other deductions.  Again, we are told to “See the Partner’s Instructions”.  While I would expect “royalty deductions” are entered on Page 1 of Schedule E, where do the rest of these deductions go?

 

Of course, the taxpayer investor has absolutely no idea what these things mean – nor do they, for the most part, give a rat’s hind quarters.  They just give the multiple K-1s to their tax preparer, often as they arrive (usually after April 15^th) and expect us to figure it out.

 

The “framework” for tax “reform” talks of doing away with business “loopholes”.  The answer to fixing the dreaded limited partnership K-1 would be to do away with all the “loopholes” and Internal Revenue Code Sections that create the confusing and convoluted components of “other income” and “other deductions” identified above, and have ONE net income item for either “ordinary business income(loss)” or “net rental income(loss)” to report all “non-portfolio” income and deductions, include all portfolio income from all sources in the appropriate boxes 5 through 10, and limit “other deductions” to the traditional Section 179 deduction, charitable contributions, investment interest, and miscellaneous “portfolio” expenses.  I hope this is part of what the “framework” is talking about.

 

I would be interested in hearing from other tax pros about the dreaded limited partnership investment K-1.

 

TTFN

 

 

 

 

 

 

 

 

TAX EFFICIENT INVESTING

You have several options available for investing your current, retirement, college, and health savings.  It is important to understand the tax aspects of each option, and the tax treatment of the various types of investment accounts – currently taxable, tax-deferred, and tax-exempt - to maximize your “after-tax” earnings from your investments.

DOMESTIC STOCKS

Investment in shares of stock, both domestic and foreign, can generate qualified dividends while held and, if held for more than a year, long-term capital gains when sold.  Qualified dividends and long-term capital gains are taxed at a special lower rate, from 0% (no federal income tax) to 20%, depending on your level of overall net taxable income.  Short-term capital gains (from the sale of stock held for one year or less) are taxed at ordinary income rates, from 10% to 39.6%.

Qualified dividends and long-term capital gains are also taxed at the special lower rate under the dreaded Alternative Minimum Tax (AMT).  However this type of income increases your Alternative Minimum Taxable Income (AMTI) and may cause you to become a victim of AMT and/or reduce your AMT exemption.

And, depending on your level of Adjusted Gross Income (AGI), all dividends and capital gains may be subject to the 3.8% Net Investment Income Tax.

Distributions from tax-deferred accounts, retirement accounts like a traditional IRA or 401(k) and the various self-employed retirement accounts, are taxed at ordinary income rates regardless of the source of the income within the account - so qualified dividends and long-term capital gains earned within a tax-deferred retirement account are taxed at ordinary income rates when the money is withdrawn from the account.

While taxable distributions from a tax-deferred account will increase AMTI, these distributions are not subject to the Net Investment Income Tax.

Stock investments that will generate qualified dividends and long-term capital gains are taxed less if held in currently taxable accounts.

If you, or your broker, are more of a day trader, and invest in some stocks for quick turn-over short-term gains, these stocks could ultimately generate more net after-tax income if held in tax-deferred accounts. 

Regardless of where held the gains will be taxed at ordinary income rates, but holding these investments in retirement accounts will defer the taxation of gains to the future, in future dollars, when distributions are made after retirement (and when your marginal tax rate, or all tax rates, could be less than they are now).  And holding them in deferred accounts will allow for greater eventual growth as a result of the tax deferral.

I am not telling you not to invest tax-deferred funds in stocks that generate qualified dividends and long-term capital gains.  You obviously want to earn as much as possible within a tax-deferred account.  Even though you may lose the benefit of the lower tax rate, you may make up for this by the increased tax-deferred accumulation of income that will ultimately be taxed in the future in future dollars.

What I am saying is that when considering how to invest funds in currently taxable accounts it is more “tax efficient” to choose investments that will generate income taxed at the lower capital gain rates.

INTERNATIONAL STOCK

While the same considerations I discussed under domestic stocks apply to international, or foreign, stock (the stock of a company organized and located outside of the United States), the dividends from international stock will often have foreign tax withheld. 

Foreign tax withheld from dividends generated by currently taxed investments can be taken as a credit - often a 100% dollar for dollar credit against current income tax liability.  Unused credits can be carried forward to be used in future years.

While foreign tax withheld from dividends generated by investments held in a tax-deferred retirement account will reduce the income that is eventually taxed, you do not get the benefit of the tax credit.

You should hold investments in international stock in currently taxable accounts.

TAXABLE BONDS

Bonds pay interest.  Interest is always taxable at ordinary income rates.

Interest on bonds and other direct obligations of the US Government (such as savings bonds and Treasury bonds and notes), while fully taxed at ordinary rates on the 1040, are exempt from state income tax.  

Taxable bonds are a good investment for tax-deferred retirement accounts.

TAX-EXEMPT BONDS

The interest from municipal bonds (issued by the 50 states and the District of Columbia, and the bonds of US possessions like Guam, Puerto Rico and the Virgin Islands) are exempt from the “regular” federal income tax, and the state income tax of a “resident” state (interest from bonds issued by the state of NJ or a NJ municipality, and US possessions, are exempt from NJ state income tax).  Interest from certain “private activity” municipal bonds are taxable under the dreaded AMT.

You should never purchase tax-exempt bonds in a tax-deferred account.

Distributions from a tax-deferred retirement account are subject to federal income tax at ordinary income rates regardless of the source of the income within the account - so interest on tax-exempt municipal bonds earned within a tax-deferred retirement account are taxed at ordinary income rates when the money is withdrawn from the account.

REAL ESTATE INVESTMENT TRUSTS

INVESTOPEDIA tells us that a Real Estate Investment Trust, or REIT, is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.

Generally the dividend payments issued by a REIT are taxed at ordinary income rates.

REITs should be held in tax deferred accounts.

LIMITED PARTNERSHIPS

My personal, albeit selfish, advice is never invest in limited partnerships in a currently taxable account.

Long-time readers of TWTP know that I hate K-1s from limited partnership investments.  Properly reporting all the items from the K-1, including those buried in attached statements, on the taxpayer’s Form 1040, and keeping track of suspensions, carry forwards and tax basis, causes considerable pain in various parts of the anatomy of a tax preparer.  And the additional tax preparation costs that result can be more than, or at least take a large bite out of, any eventual tax and financial benefits from the investment.  I truly believe that a carefully researched mutual fund will provide the same potential tax and financial benefit as any limited partnership investment (and welcome the comments of brokers on this statement).

If your broker insists that you must purchase units in a limited partnership, and no mutual fund will provide the same tax and financial benefits, then purchase the partnership in your IRA, traditional or ROTH, or another tax-deferred or tax-exempt account, so you tax professional does not have to deal with it on the 1040.

MUTUAL FUNDS

Mutual funds invest in all types of investments – domestic and international stocks, taxable and tax-exempt bonds, real estate, and limited partnerships.

Some funds invest in a mix of all investments and some funds limit investments to specific categories – small cap stock funds, growth stock funds, dividend paying stock funds, non or low dividend paying stock funds, international stock funds, corporate bond funds, either domestic or international, government bond funds, municipal bond funds, etc. etc. etc.

The taxability of dividends issued by mutual funds is determined by the rules for taxing the individual investments in the fund. Choosing what types of funds you purchase in currently taxed and tax-deferred accounts should be governed by the types of investments held in the fund.

Mutual funds can issue qualified dividends, non-qualified dividends, tax-exempt dividends, return of capital, and capital gain distributions.  Non-qualified dividends are taxed at ordinary income rates.  Return of capital distributions are not currently taxed as income – they reduce your cost basis in the fund.  Capital gain distributions are taxed at the lower capital gain tax rates.

There are “tax-efficient” mutual funds.  These funds can keep it's turnover low, especially if the fund invests in stock, and avoid or limit income-generating assets, such as dividend-paying stocks.  These funds should be held long-term in currently taxable accounts.

TAX-EXEMPT ACCOUNTS: ROTH IRAs AND 401(K)s, EDUCATION ACCOUNTS, HEALTH SAVINGS ACCOUNTS, AND MEDICAL SAVINGS ACCOUNTS

It really does not matter how you invest funds held in accounts whose distributions will never be taxed. 

Qualified distributions from a ROTH IRA or 401(k) account, a Section 529 qualified tuition program, a Coverdell Education IRA, a Health Savings Account, or a Medical Savings Account are totally tax free.  So taxes are not a consideration in determining where to invest the money.  Obviously you want to make sure that all distributions from these types of accounts are qualified distributions.

Before you invest you should consult a tax professional.  Do not rely on a broker for tax advice.

TTFN

I HATE K-1s!

The titular character of KISS ME KATE hated men.  I hate K-1s with equal fervor.  Especially those for limited partnership, publicly traded or not, investments.  I can live with K-1s for actual business activities, although they, too, have issues.

 

All K-1s usually arrive late – anytime from the end of March to the beginning of September – more often than not causing the client’s return to be extended.  I hate GD extensions just as much as I hate K-1s (the GD is not "government deferred" or anything similar - it stands for exactly what you think it does).

 

As limited partnership investments, again publicly traded or not, are passive activities, there is added complexity, work, and agita involved in (1) determining whether or not, and how much of, the various types of income, deductions and losses from the K-1 are reported on the current Form 1040 and corresponding state tax return, and the multitude of forms and schedules thereof, (2) keeping track of “suspended” losses, and (3) keeping track of “outside basis”.

 

I have seriously considered telling my clients that I will no longer do tax returns for individuals who have in their current portfolio limited partnership investments that produce K-1s.  But I have not.   

 

While I have not done any specific calculations, I firmly believe that often the additional costs to properly prepare the federal and state income tax returns for taxpayers with K-1 investments is as much as or more than the actual income, or tax benefits if any, generated from the investment.  If the money invested in these limited partnerships were instead invested in related mutual funds I expect the investor would do better.  His/her tax preparation costs would certainly be less.

 

Of course brokers never tell their clients this when selling them the investment.

 

I have no personal knowledge of this, but I suspect that brokers receive a larger commission from selling units of limited partnership investments than they do from selling shares of stock or mutual funds.  I would truly appreciate hearing from anyone “in the know” whether or not my suspicion is true.

 

The bottom line to this post is this – think very carefully before permitting your broker to purchase a limited partnership investment (unless it is in an IRA account, which has no reporting requirements).  Do some research to be sure that the income or growth potential of the limited partnership investment is truly “more better” than a more traditional investment in stock or mutual fund shares. 

 

Any comments?

 

TTFN