Making the switch from employee to business owner requires some getting used to. One of those adjustments is understanding the difference between the income reported on a K-1 and the amount of cash distributions received. Let’s look at some of the reasons why this happens.
Taxable income is not always the same as cashflow
When you are paid a salary, the taxable income that appears on your W-2 is generally close to the amount of cash deposited in your bank account over the year. But that’s not always the case when you own a business.
A K-1 reports the partner’s or shareholder’s allocated portion of the income earned by the whole business. Tax rules for recognizing income do not always mirror the actual flow distributions to the shareholder or partner. When it comes to the amount of tax due, it is the K-1 income that matters most, not necessarily the amount of cash distributed (assuming there is sufficient basis).
For example, suppose an S-corporation is trying to build up its cash reserves, either for an emergency or some future investment. In that case, the company may retain all or most of its earnings and the K-1 income could be far greater than the amount of cash distributed.
This issue also arises when there are loan repayments. For example, if an S-corporation made loan payments of $12,000 for the year, but only $500 of that amount was deductible interest, taxable income will be $11,500 higher than the actual cash outflows.
These are just a few of the reasons why K-1 income and actual cash flows can be different. Ultimately, a business is an asset like a savings or investment account. As a result, sometimes tax will be due on earnings even if you do not receive the actual cash. Properly managing the tax impact of K-1 income is an important part of becoming a successful business owner.
If you have questions, please contact our offices.