Some clients may be new to certain tax forms. By helping to demystify the process, you can strengthen their relationship with your practice.
As a professional advisor, you're always looking for chances to help your clients, including staying ahead of their questions so they don't get surprised. Taxes are one big opportunity, particularly for clients who may not understand the ins and outs of the Schedule K-1. If you have clients who may not have received a K-1 before, they may not be clear about what they're supposed to do with it. That confusion is a chance for you to step in, before they even receive the paperwork, and help explain the process so they know what to expect.
To be clear, unless you are licensed to give tax advice, you need to keep these conversations at the general level and refer clients to their own tax professionals.
Here are some ways to make sure you get the conversation right.
Start with the Basics of the Investment Type
Before jumping straight into the tax implications of a particular investment, give them a quick refresher on how that investment works and its intended role in their portfolio. For example, alternative investments may provide diversification to a traditional portfolio comprised of stocks and bonds. This is just a quick overview—you've already had more detailed conversations about these assets in the past—but it's best to assume the client may not remember some of the key details.
Explain the Schedule K-1
You already know how a K-1 works, but make sure you explain the concept at your clients' level of understanding, not yours. (In other words, give them a break and keep it simple.) The basic gist: some types of investment structures—like partnerships, limited liability companies (LLCs), and subchapter-S corporations—do not pay corporate income tax on their profits or deduct losses. Instead, they ultimately transfer the profits and losses to their investors, who settle the taxes as part of their individual tax returns. That structure is designed to offset double taxation, in which company profits are federally taxed at the corporate level and again at the investor level. Schedule K-1s are how these companies report profits and losses to the IRS and to their investors.
Understanding the Numbers
The information on the K-1 forms varies depending on the activity of the entity reporting, but in general it will list income, losses, credits, and distributions. Notably, an investor's distributions for a given year will likely be different than the profits and losses that show up on the K-1. Why? The K-1 filing is based on the entity's overall income for the year, allocated to each investor. Some entities may opt to reinvest income to fuel growth, or they may have non-cash deductions like depreciation.
Give a High-Level Summary of the Individual Forms They'll Need
Anyone who receives a K-1 needs to prepare the corresponding paperwork on his or her individual taxes. For example, investors need to report the name and tax identification number of the investment on a Schedule E as well as certain amounts from the K-1. If their K-1 reflects dividends or interest they'll also need to report those on a Schedule B. And for some investments, clients may need to file other forms as well as file taxes in other states based on where the investment operates. (Again, your goal is not to help them prepare their taxes but rather to let them know what's coming, when they start that process with their own tax advisor.)
Talk Through the Timing
Most traditional tax documents have to be mailed out by mid-February. Schedule K-1s typically come a little later—companies have until March 15 and, if they extend, K-1s can be sent as late as September 15. That's because companies need to finalize their own financial statements for the year before they can issue K-1s. And some companies have a fiscal year that doesn't match the calendar year—meaning some K-1s will get sent out throughout the year. Investors in those companies may need to include this information on their taxes for the following year.
Recommend That They Talk to a Tax Professional
Finally—and most important—you should suggest that your clients work with a tax professional in preparing and filing their taxes. They may not have used a tax pro in the past, especially if their financial situation has been straightforward. But as they move into more sophisticated investments, their taxes are going to become more complex. An expert can help them navigate the process each year, keep them apprised on changes to tax laws, and possibly even recommend measures that save them some money.
In sum, your clients probably don't love tax season, and it can be particularly daunting for clients receiving K-1s for the first time. If you can be proactive and offer some clear guidance about the process, you can make the process a little more bearable, establish your expertise, and strengthen your client relationships.
The information contained herein is provided only as a summary of complicated topics and does not constitute tax, investment or other professional advice. The information is not all-inclusive and should not be relied upon as such.
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