Inheritances generally aren’t taxable, at least not at the federal level and not as income, but some exceptions do exist. In most cases, you can collect your gift from a deceased friend or relative and never concern yourself with reporting the event to the Internal Revenue Service. In other cases, however, your gift will kick off income, and this changes things.
Maybe it’s an investment that earns interest or produces dividends. The gift itself still isn’t taxable, but its earnings are. Schedule K-1 tells you – and the IRS – that your inheritance has earned income and how much.
Who Files a K-1 Tax Form?
You don’t have to complete Schedule K-1 as a beneficiary, and in most cases you don’t have to file the copy you receive with the IRS. This is the estate’s responsibility. The estate might be a probate estate, or it might be a living trust. The executor or trustee is the one who must deal with this federal tax schedule. It goes hand in hand with Form 1041, the U.S. Income Tax Return for Estates and Trusts.
There’s a major distinction between Form 1041 and Form 706, the federal return for estate taxes. Form 1041 doesn’t tax the estate’s value but only any income it earns during the year. Estates and trusts must file income tax returns when they have gross incomes of $600 or more in the tax year. They must also do so regardless of earnings if any beneficiary is a non-resident alien.
When the estate gives some or all of that income to its beneficiaries, the trustee or executor must send those beneficiaries Schedule K-1s showing the details of the gift, as well as any deductions or credits the beneficiary might have shared in. He must also file a copy with the IRS. The beneficiary would then report this income on her personal tax return.
How to Fill a K-1
That sounds relatively simple, doesn’t it? It might, until you actually look at the K-1 tax form you’ve received. It’s two pages. The second page is just a list of codes relating to other information on the form, but there are a lot of codes.
The situation can seem even more confusing because there’s more than one kind of Schedule K-1. One of these forms deals only with income received from a partnership. But each is clearly labeled at the top as to which type of income it relates to.
You might notice that Box F under Part II of the K-1 tax form, a space designated for your “identifying number," is just a lot of X marks with four digits at the end. Your identifying number is typically your Social Security number and these are the last four digits.
Sometimes the executor or trustee will block the other numerals out for security reasons, to protect you if the schedule should fall into the wrong hands. Rest assured that the copy the IRS receives will include your entire number. The IRS will be able to identify you.
Understanding the Other K-1 Information
The spaces included in Part I of the K-1 tax form identify the trust or estate. Those in Part II include some basic information about you, such as your address and your status as a U.S. citizen or legal resident. Part III provides the financial details of your inheritance.
Boxes 1 through 8 in Part III explain the details of what type of income you received. You can match up the information in Boxes 9, 11, 12, 13 and 14 with the codes on the second page of the form to identify the details of your inheritance.
You’ll find amounts in these boxes as well. If an asterisk appears beside any of this information, it means that another form or forms should be attached to your Schedule K-1 with more information relating to this particular box.
K-1 Meaning to the Estate
Box 10 shows the amount of any deduction the estate or trust took for income that was passed on to you. You and the estate or trust don’t both have to pay taxes on this income. If your particular bequest kicked off $1,000 in interest, the estate or trust will note that amount here, deducting the same amount from the income it must pay taxes on when it completes and submits its own tax return.
Maybe the estate or trust earned $50,000 all year overall. It must report this $50,000 on its own tax return. But by claiming a deduction for the $1,000 it passed on to you, and by noting that amount in Box 10 of your Schedule K-1, the estate or trust gets a corresponding tax deduction for that amount. It now pays income tax on only $49,000 because you’re expected to pay the income tax on the $1,000 you received.
How Your Inheritance Is Taxable
So now what exactly do you do with all this information? How do you report it and pay taxes on it?
Remember, your bequest itself isn’t taxable as income under IRS rules, and the federal government doesn’t have an inheritance tax. So that base amount you received is tax-free. But you’ll most likely receive your bequest lumped together with whatever interest or income your particular gift earned before it was transferred to you, and this can complicate things.
For example, you might receive a check for $6,000. Of that amount, $1,000 is taxable earnings produced by your bequest of $5,000. Your Schedule K-1 will tell you and the IRS how much of that $6,000 was taxable earnings and how much was a bequest. You must report the $1,000 in earnings on your personal return.
The timing matters, too. If $500 of that $1,000 was earned before the decedent’s date of death, you might receive that $500 as part of your bequest, but it’s taxable to the estate. You’d only have to report and pay taxes on the $500 earned after the date of death through the time when you received the inheritance.
Calculating How Much You'll Owe
When you’ve completed your tax return and all is said and done, the income generated by your bequest will be included with all your other taxable income after you claim your own personal deductions and credits. It’s therefore taxed at your marginal tax rate according to your tax bracket, just like all your other income.
But here's a bit of a silver lining: Were the trust or estate to pay the income taxes on that $1,000, it would have been subject to a higher tax rate. More of your inheritance would have been lost to taxation. Because you personally pay a lower tax rate than what the estate or trust must pay, more of that $1,000 will stay in your pocket even though you have to report the income. There is no special K-1 tax rate.
Of course, if you inherit something like an investment account rather than cash, all income earned by it after you receive it – assuming you don’t immediately cash it in – remains your responsibility. The estate or trust took a bow and backed out of the tax situation when it transferred the inheritance to you. Again, earnings generated would be taxed along with your other income according to your tax bracket going forward for as long as you keep the account intact.
Understanding Required Distributions
If you’ve inherited from a trust rather than a probate estate, you might dodge having to report and pay taxes on the gift’s earnings on your personal tax return under one circumstance.
Only required distributions from an estate are taxable. With a probate estate, this is everything. The last will and testament says that everything in the estate – everything the decedent owned at the time of his death – should go to someone or something. The estate can’t close until this happens. It’s known as a required distribution.
The same applies to distributions from a trust that are made according to the trust’s terms. In both cases, the beneficiaries have an entitlement to those bequests. Thus, they’re taxed on income produced by them. But trusts can sometimes make discretionary distributions.
Let's say that the trust’s formation documents don’t specifically dictate that you should receive $5,000 from the estate. Rather, the terms leave it up to the trustee to pay you when and how he sees fit. Maybe the trustee realizes that you’re really struggling financially right now and he wants to help you out so he kicks $1,000 your way. This is taxable to the trust, and the trust cannot take a tax deduction for the amount.
Filing Form K-1 With Tax Return
You generally don't have to file a copy of your K-1 tax form with your income tax return because the IRS already has the copy provided by the executor or the trustee. But an exception exists if Code B appears in Box 13 of your Schedule K-1. This means that your bequest was subject to backup withholding for some reason. In this case, the IRS wants you to include a copy of the schedule with your tax return.
Disputing Mistakes on K-1 Forms
Let’s face it, trustees and executors are only human, just like the rest of us. If you think some information on your Schedule K-1 is wrong, maybe because you didn’t receive as much from the estate as was attributed to you, you’re not without recourse.
The IRS advises that you should first let the trustee or executor know that you don’t agree with the reported information. In a best-case scenario, he’ll say, “Oops,” and he'll issue you an amended Schedule K-1. Make sure he also sends an amended copy to the IRS.
In a worst-case scenario, he’ll tell you that you’re wrong – the information on the K-1 tax form is accurate. You might want to touch base with a tax professional in this case to make sure your understanding of the situation is correct. This is, after all, a somewhat complicated tax issue.
If indeed you’re right and the trustee or executor is wrong, you can file Form 8082 with the IRS, alerting them to the disagreement. Then report the amount you think you owe taxes on, but again, only after getting expert advice.
State Laws For Inheritances
Finally, there’s one last caveat here. Schedule K-1 is a federal form. Your state might have its own way of treating inheritances.
Although the IRS doesn’t tax inheritances – just the income they produce – some states do both. Pennsylvania, New Jersey, Maryland, Iowa, Kentucky and Nebraska all had an inheritance tax as of November 2020.
Each of these states has its own unique rules, but most do not tax surviving spouses and some don’t tax the children of a decedent, either. At least, they don’t impose an inheritance tax on these individuals. Income taxes could be another matter, so always check with a tax professional to determine where you stand at the state level.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.