K-1 Income vs. Distributions: A Tax Guide for Small Businesses

Many small business owners are surprised to discover that their tax bill doesn’t always match the cash they received. If you’re a partner in a partnership or a shareholder in an S corporation, you likely receive a Schedule K-1 at tax time. But here’s where it gets tricky: the income shown on your K-1 might be taxable even if you didn’t receive a dime in cash. And cash distributions? They might be tax-free—or not.

Understanding the difference between K-1 income (allocation of business results) and distributions (cash/property payouts) isn’t just an accounting technicality. It can impact your self-employment tax liability, capital gains exposure, and even how much cash you should set aside for estimated tax payments each quarter. This guide breaks it all down to help you make smart, tax-savvy decisions for your business that minimize surprises. 

Key Highlights

Browse these crucial insights and takeaways to maximize your understanding of this topic. 

• K-1 income is taxable whether or not you receive cash from the business.

• Distributions may be tax-free, but only if you have sufficient basis.

• Partnership income is usually subject to self-employment tax if you're an active partner.

• S corp K-1 income isn't subject to self-employment tax, but a reasonable salary must come first.

• Phantom income occurs when you're taxed on profits not distributed as cash.

• Tracking basis annually (via IRS Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations) is crucial to avoid unexpected tax bills.

• Excess distributions over basis result in capital gains.

• Choosing the right entity can optimize both tax savings and administrative ease.

What the K-1 Shows vs. What a Distribution Is

Partnerships (Form 1065 K-1)

In partnerships, the K-1 reports your share of various income types:

• Ordinary business income

• Capital gains

• Interest

• Miscellaneous income

It also includes any guaranteed payments, which are treated as ordinary income to the recipient and are deductible by the partnership. These payments are distinct from partnership distributions tax and are always taxable. This is the main distinction when considering guaranteed payments vs. distributions.

S Corps (Form 1120-S K-1)

In an S corp, the Schedule K-1 allocates business income to shareholders; however, this income is not subject to self-employment tax. Distributions aren’t reflected on the K-1 when they qualify as dividends—they appear instead on IRS Form 1099-DIV, Dividends and Distributions.

Non-dividend distributions reduce your stock basis and may become taxable if your basis is exhausted. Shareholders should use Form 7203 to accurately track their basis.

How Each Is Taxed (By Entity)

Partners (Active vs. Limited)

Active partners are subject to self-employment tax on their share of income. This includes most general partners. The self-employment tax rate is 15.3% and applies to the majority of net earnings. The limited-partner exception exists but is extremely narrow and has been challenged in court. 

Passive K-1 items, such as interest or dividends, may also be subject to the 3.8% Net Investment Income Tax (NIIT) if income exceeds IRS thresholds.

S Corp Shareholders

K-1 income for S corp shareholders is not subject to self-employment tax. However, the IRS requires shareholder-employees to receive reasonable compensation in the form of W-2 wages, which are subject to self-employment tax. 

If this requirement is not met, the IRS may reclassify distributions as wages, resulting in payroll tax consequences that erase one of the primary benefits of operating as an S corporation. 

Basis Basics That Decide If Distributions Are Taxable

Partnership Outside Basis

In a partnership, your outside basis includes your:

• Capital contributions

• Allocated income

• Share of the partnership’s debt

Distributions reduce this basis. If you receive more in distributions than your current basis, the excess is taxed as a capital gain.

S Corp Stock/Debt Basis (Form 7203)

For S corp shareholders, basis is tracked through Form 7203 and follows specific ordering rules. 

• Distributions are tax-free to the extent of your basis. 

• Once your basis is reduced to zero, any further distributions are taxed as capital gains.

• Dividends from accumulated C corp earnings are reported separately on Form 1099-DIV.

Quick Scenarios (Show the Math Simply)

Active Partner (Partnership)

In this scenario, an active partner receives a K-1 showing $100,000 in profit. They take a $50,000 cash distribution. Their basis increases with the income and decreases with the distribution.

They owe income tax and self-employment tax on the full $100,000 profit.

S Corp Owner

In a similar scenario, an S corp shareholder takes a $60,000 salary and receives a $40,000 distribution. Their K-1 shows $100,000 in income. They owe payroll tax on the $60,000 salary, but the distribution is not subject to self-employment tax. The basis increases by $100,000 and decreases by $40,000.

Mistakes to Avoid & Planning Moves

Phantom Income & Cash Policy

K-1 income is taxable regardless of whether you receive cash. This phenomenon—phantom income—can create tax liabilities without liquidity. To avoid this, establish distribution policies and ensure estimated tax payments align with business profits.

Excess Distributions Over Basis

Receiving distributions that exceed your basis triggers capital gains. S corp owners should use Form 7203 to monitor this annually. To avoid surprises, partnerships must calculate outside basis annually.

Paying Yourself Correctly

Misclassifying compensation can result in IRS penalties, as they all have different tax implications: 

• Guaranteed payments for partners

• Wages for S corp shareholders

• Distributions

Use a full-service payroll solution to stay compliant while saving countless hours per pay period. 

When to Rethink Entity Choice

If profits are growing or your administrative workload increases, consider whether your current structure still fits. An S corporation election may offer tax savings, but it also comes with additional compliance obligations.

Affordable, tax-deductible business tax advisory from 1-800Accountant can help assess your options.

FAQs About K-1 Income and Distributions

Is K-1 income the same as a distribution?

No. K-1 income reflects your share of business profits, while distributions are actual payments. You may owe tax on income reported on your K-1 even if you didn’t receive cash. 

Learn what Schedule K-1 reports. 

Do I pay self-employment tax on K-1 income?

It depends. General partners usually owe self-employment tax on their distributive share. S corp shareholders do not, but they must receive reasonable compensation in the form of S corp wages. Limited partners may qualify for an exception, but it's rarely applicable. 

Learn more about self-employment tax rules, the limited-partner exception, and reasonable compensation.

Are distributions always tax-free?

Not necessarily. Distributions are tax-free up to your basis. Anything beyond that is subject to capital gains tax. However, for S corps with C corp earnings, some distributions may be taxed as dividends.

Learn more about partnership distribution rules and S corp distributions.

Why do I owe tax on income I never received? (“phantom income”)

Tax on income you never received is known as phantom income. Since K-1s report allocated profits, not cash received, you can be taxed on retained business earnings. Plan ahead with distributions and quarterly tax payments to ensure timely compliance.

Learn more in our Schedule K-1 tax form guide.

How do I track my basis to avoid tax surprises?

Partnerships use outside basis, adjusting annually for income, contributions, and distributions. S corp shareholders must file the shareholder basis Form 7203 with their returns to track stock and debt basis.

Read more about shareholder basis rules.

Do I owe NIIT (3.8% Net Investment Income Tax) on K-1 income?

If your Schedule K-1 income is passive and your modified adjusted gross income exceeds IRS thresholds, the 3.8% NIIT applies.

View the IRS 3.8% NIIT on passive vs. active K-1 income guide for more details. 

How does reasonable compensation affect S Corp taxes?

The IRS requires shareholder-employees in S corps to take a fair W-2 wage before distributions. If wages are unreasonably low, the IRS may reclassify distributions and assess payroll taxes, erasing potential tax savings. 

Familiarize yourself with reasonable compensation rules.

Need Help With K-1s, Basis Tracking, or Payroll?

At 1-800Accountant, America's leading virtual accounting firm, we help small businesses untangle complex tax situations with affordable, tax-deductible services done for you. From entity formation to year-round tax advisory and K-1 prep, we’re your full-service partner.

Schedule your complimentary 30-minute call today to get a glimpse of how much you can save with professional tax support.