IRS Updates Form 1065 & Schedule K-1 Instructions for Tax Year 2025
If you manage a partnership or prepare Form 1065 for clients, the IRS has released updated guidance you need to review before filing 2025 returns. The updated Form 1065 instructions for 2025 and revised Partner’s Instructions for Schedule K-1 (Form 1065) — finalized in January 2026 — introduce new reporting codes, a simplified K-2 exception, and direct deposit capability for overpayments. At SW Accounting & Consulting Corp, we have reviewed every change so you do not have to. This guide breaks down everything that matters for your partnership return.
What Is Actually New in Form 1065 and Schedule K-1 for Tax Year 2025? 📋
The 2025 versions of Form 1065 and Schedule K-1 are mostly unchanged from 2024, but two notable additions to the form itself stand out alongside a significant set of new reporting codes.
First, direct deposit lines have been added to Line 32 (overpayment) on Form 1065. This allows partnerships to receive overpayment refunds directly into a bank account, eliminating delays from paper checks. For partnerships that overpay estimated taxes, this change meaningfully speeds up cash flow.
Second, a new checkbox has been added to Line 16b of Schedule K, allowing a partnership to indicate that it qualifies for an exception to filing Schedule K-2 (Form 1065). Schedule K-2 is used to report partners’ distributive share of items of international tax relevance. For domestic partnerships with no foreign activity, the K-2/K-3 requirements have been a significant compliance burden since they were introduced for tax year 2021. The new checkbox formalizes the domestic exception and simplifies reporting for the vast majority of small to mid-size domestic partnerships.
In our practice, many small domestic partnerships have struggled with Schedule K-2/K-3 requirements. The new Line 16b exception checkbox is a much-needed simplification. If your partnership has all US partners and no foreign income, taxes, or international items, you can now formally claim the exception by checking the box and skip Schedule K-2 entirely. We always recommend confirming eligibility with a qualified CPA, but for most of our clients this will be a significant time and cost savings.
What Are the New Line 19 Codes for Partnership Distributions on Schedule K-1? 💰
Three new codes — Code D, Code F, and Code G — have been added to Line 19 of Form 1065 and Box 19 of Schedule K-1 to classify specific types of partnership distributions more precisely.
These new codes were introduced for two reasons: to reduce confusion around long-misunderstood provisions of partnership tax law, and to implement new provisions enacted under the One Big Beautiful Bill Act (OBBBA). Here is a full breakdown of all Line 19 codes for 2025:
| Code | Description | Status |
|---|---|---|
| A | Cash and marketable securities distributions (not for services) | Existing |
| B | Property distributions subject to IRC Section 737 | Existing |
| C | Other property distributions (non-cash, non-marketable securities) | Existing |
| D 🆕 | Deemed cash distributions under IRC Section 752(b) — decrease in partner’s share of partnership liabilities or partnership assumption of partner’s individual liabilities | NEW for 2025 |
| F 🆕 | Distributions of cash to partners for providing services | NEW for 2025 |
| G 🆕 | Distributions of non-cash property to partners for providing services | NEW for 2025 |
Code D — IRC Section 752(b) Deemed Distributions: When a partner’s allocable share of partnership liabilities decreases — because the partnership pays off a shared debt, refinances at a lower balance, or assumes a partner’s personal liability — that decrease is treated as a deemed cash distribution. If the deemed distribution exceeds the partner’s adjusted outside basis, the excess is taxable gain. Prior to 2025, there was no dedicated code for this, creating ambiguity. Code D eliminates that ambiguity.
Codes F and G — Service-Related Distributions: Partnerships that compensate partners through distributions in exchange for services must now use Code F (cash) or Code G (non-cash property) specifically for those service-related distributions. These distributions may generate ordinary income to the partner. Real estate partnerships, investment funds with managing partners receiving promoted interests, and service-based LLCs with profit-sharing arrangements should review their 2025 distributions carefully.
Using the wrong distribution code on Schedule K-1 can cause partners to misreport income, leading to IRS matching discrepancies or underreporting penalties. With Codes D, F, and G now required for specific distribution types in 2025, do not default to Code A for all distributions. Conduct a distribution audit before preparing the 2025 Form 1065.
What Are the New Line 20 Codes (Code AZ and Code ZZ) for Other Transactions? 🔍
Two new codes — Code AZ and Code ZZ — have been added to Line 20 of Schedules K and K-1 for specific events or transactions beyond ordinary distributions.
Code AZ — Preformation Expenditure Reimbursements: When a partner contributes property and is later reimbursed for costs incurred before the contribution (preformation expenditures), this can trigger the disguised sale rules under IRC Section 707. Treasury Regulations Section 1.707-4(d) provides an exception for legitimate preformation expenditure reimbursements. Code AZ reports these reimbursements, giving the partner documentation to support the disguised sale exception.
Code ZZ — Qualified Farmland Gain under IRC Section 1062: This is a new provision under the One Big Beautiful Bill Act. When partnerships sell qualified farmland property to qualified farmers, the resulting capital gains are reported via Code ZZ. Partners receiving this code may elect to pay their share of the gain in installments — a significant cash flow benefit for agricultural partnerships transferring land to qualified buyer-farmers. The election is made at the partner level.
How Do These Form 1065 Updates Affect Partnership Tax Planning for 2025? 📊
These changes require partnerships and advisors to review distributions and transactions with greater precision for the 2025 tax year.
- K-2 exception eligibility check: Confirm all partners are US persons and no international tax items exist. Check Line 16b to claim the exception and skip K-2/K-3.
- Liability allocation review: Any decrease in a partner’s share of liabilities creates a Code D deemed distribution — which may trigger gain if it exceeds outside basis.
- Identify service distributions: If any partner received a distribution for services performed in 2025 — managing partners, promoted interest holders — determine whether Code F or G applies.
- Agricultural partnerships — farmland sales: If your partnership sold qualified farmland to a qualified farmer in 2025, use Code ZZ and advise partners of the installment election under IRC Section 1062.
- Preformation reimbursements: If any partner received a reimbursement for preformation costs, report under Code AZ and preserve documentation for the disguised sale exception.
- Overpayment routing: With direct deposit now available on Line 32, update banking information for faster refund processing.
We recently worked with a Southern California real estate limited partnership that had a managing partner receiving a profit-based distribution for overseeing property management. Under prior practice, this was being reported under Code A. Under the 2025 instructions, distributions for services must now be evaluated for Code F or G treatment. We correctly classified the distribution as Code F (cash for services) and ensured the managing partner’s K-1 properly reflected the income character — avoiding potential IRS scrutiny and ensuring consistent filing.
How to Submit Feedback on the 2025 Form 1065 Instructions 📩
The IRS is actively inviting feedback on the 2025 instructions to inform the development of tax year 2026 forms. Submit comments at IRS.gov/FormsComments using these subject lines:
- Form 1065 Instructions: subject line “Instructions for Form 1065”
- Schedule K-1 Instructions: subject line “Partner’s Instructions Schedule K-1”
Tax professionals who work with partnership returns regularly have a meaningful opportunity to shape how these instructions evolve. The new codes — particularly Codes F, G, and D — may benefit from further clarification in future guidance.
