The Latest in the Schedule K-2 and K-3 Sagaby
Partnerships and S corporations with no foreign activities, foreign partners or shareholders, and without knowledge of partners or shareholders needing information on items of international relevance will not have to file the new Schedules K-2 and K-3 for 2021 after all.
The IRS announced on February 15, 2022 that they are giving more transition relief for Schedule K-2 and K-3 reporting for this year.
The IRS is doing this in response to feedback from the tax community and their own stakeholders, and they will give more details of the relief announced on February 15 soon. Prior to this, those required to file Form 1065, 1120-S or 8865 were required to file two new forms this year: Schedules K-2 and K-3.
The new schedules report "items of international tax relevance" (income from foreign sources; assets generating foreign income; and foreign taxes paid or accrued). Partnerships filing Form 1065 and S Corporations filing Form 1120-S as well as U.S. persons who are partners in foreign partnerships and entities who elect to be taxed as partnerships filing Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships were struggling with the requirement.
While much of the information sought by the new schedules was already required as attachments to Schedule K-1 in the form of supplemental statements, whitepaper disclosures, pro-forma forms or footnotes, these new schedules call for more detailed information.
The new Schedules K-2 and K-3 were designed to give guidance to partnerships and S corporations on how to give international tax information to their partners and shareholders in a standardized format that gives them clarity on calculating their U.S. tax liability and international income and deductions, including provisions of the Tax Cuts and Jobs Act of 2017 (TCJA), which made significant changes to foreign items including tax credits, deductions, depreciation, and expensing.
Partnerships will use Schedule K-2 (Form 1065), Partners' Distributive Share Items - International and Schedule K-3 (Form 1065), Partner's Share of Income, Deductions, Credits, etc.-International. The new forms are an extension of Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc. Schedule K-2 is used to report items of international tax relevance from the partnership's operations. Schedule K-3 reports to partners their share of the items reported on Schedule K-2.
S-Corporations will file Schedule K-2 (Form 1120-S), Shareholders’ Pro Rata Share Items—International and Schedule K-3 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc.—International. Schedule K-2 is used to report items of international tax relevance from the S corporation's operations. Schedule K-3 reports to shareholders their share of the items reported on Schedule K-2. The new schedules are an extension of Schedule K-1 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc.
Filers of form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships reporting required information under section 6038 (controlled foreign partnerships), section 6038B (transfers to foreign partnerships), and section 6046A (acquisitions, dispositions, and changes in foreign partnership interests) will file Schedule K-2 (Form 8865), Partners' Distributive Share Items - International and Schedule K-3 (Form 8865), Partner's Share of Income, Deductions, Credits, etc.-International.
The new forms are only required to be filed if the entity has items of international tax relevance, typically foreign activities or foreign partners, there are situations where partnerships and S coporations without items of international tax relevance may still be required to file them. Changes were made to the schedules in January of 2022, adding to their complexities.
Among the list of changes were notes about "Who Must File" in changes to both the 2021 Partnership Instructions and the 2021 S Corporation Instructions for Schedules K-2 and K-3 citing the need to report information on Schedules K-2 and K-3 even if there was no foreign source income, assets generating foreign source income, or foreign taxes paid or accrued. When partners or shareholders claim a credit for foreign taxes they paid, they may need information from the partnership or the S corporation to complete Form 1116, Foreign Tax Credit (Individual, Estate, or Trust.
The note in the partnership instructions also said that partnerships with only domestic partners may still need to complete Schedule K-2, Part IX -"Partners' Information for Base Erosion and Anti-Abuse Tax (Section 59A)" if they make certain deductible payments to the foreign related parties of their domestic partners to help the domestic corporate partners determine the amount of base erosion payments made through the partnership, and to determine if they are subject to the Base Erosion and Anti-Abuse Tax.
Although Notice 2021-39 announced penalty relief during the transition period, a "good faith effort" has to be made in order to get it, including collecting and sharing information about partners and shareholders so determinations can be made on whether the new schedules need to be completed, and if so, how to complete them.
The IRS released drafts of Schedules K-2 and K-3 for Form 1065 in July of 2020, and revised drafts in April of 2021. After receiving stakeholders input on the changes, the new Schedules K-2 and K-3 were released on June 3 and 4, 2021. The final instructions made clarifications that were requested as to when each part of the schedules were applicable, and that only applicable parts of the schedules need to be be completed. Instructions were also given for requested separate schedules used in determining the section 250 deduction (foreign-derived intangible income and global intangible low-taxed income) and the allocation and apportionment of expenses.
Since prior requirements called for attachments rather than being included on the K-1, it's important to go back over past years to see if the requirements were actually fulfilled. This can be a burdensome but necessary task; however, the new schedules are not sudden, so those required to use them have had time to prepare for the change.
When penalty relief is requested, the IRS will look to see if changes were made to information gathering procedures such as software programs to prepare for the new schedules; if appropriate efforts were made to get information about partners, shareholders and controlled foreign partnerships and if any assumptions made about them were reasonable; and if partnership or other agreements were modified so that information could be collected.
Candace J. Dixon has been in practice as an accountant since 1996. She has a Bachelor's Degree in Accounting from Saint Leo University in Tampa, Florida, and is a Certified Advanced QuickBooks ProAdvisor. She specializes in taxation and advanced accounting, and is known for being well-versed in the Internal Revenue Code and the gig economy. Her...