New K-2s and K-3s: partial relief for some, burdens and delays for others

Effective for the 2021 tax year, pass-through entities with “items of international tax relevance” are required to file two new forms: Schedules K-2 (Partners’ Distributive Share Items—International/Shareholders’ Pro Rata Share Items—International) and K-3 (Partner’s/Shareholder’s Share of Income, Deductions, Credits, etc.—International). For this purpose, “international relevance” is far more expansive than expected and potentially applies to pass-through entities with U.S.-only operations. The IRS is both expanding and standardizing international reporting with the adoption of these new schedules, providing pass-through owners with more detailed information necessary to complete their returns with respect to international tax items.

Schedules K-2 and K-3 are intended for use with:

• Form 1065 – U.S. Return of Partnership Income
• Form 1120-S – U.S. Income Tax Return for an S Corporation
• Form 8865 – Return of U.S. Persons with Respect to Certain Foreign Partnerships  

This tax alert addresses a temporary reprieve from the expanded filing requirement for qualifying pass-through entities as well as delays the IRS is experiencing with electronically accepting these new forms.

Background

In the summer of 2021, the IRS released draft Schedules K-2 and K-3, which limited reporting requirements to pass-through entities with “items of international tax relevance,” generally defined as entities with foreign activities and/or foreign owners. This development was covered in the U.S. international tax and transfer pricing update in our 2021 year-end tax letter.

On Jan. 18, 2022, the IRS released final instructions for Schedules K-2 and K-3 containing extremely broad filing requirements, capturing many pass-through entities with no apparent “items of international tax relevance” — broadly meaning no foreign activities (e.g., no foreign investments, no foreign source income, no assets generating foreign source income and no foreign taxes paid or accrued). Surprisingly, the instructions require entities to complete certain sections of Schedules K-2 and K-3 if the information reported could affect the determination of an owner’s ability to calculate and claim foreign tax credits. To utilize a filing exemption, the pass-through entity must have knowledge that a section is not applicable to all partners or shareholders (both direct and certain indirect).

For example, if any partner in a partnership (or shareholder in an S corporation) is eligible to claim a foreign tax credit through filing Forms 1116 (Foreign Tax Credit (Individual, Estate, or Trust) or 1118 (Foreign Tax Credit—Corporations), the instructions require the partnership or S corporation to complete Parts II and III of Schedules K-2 and K-3. The filing requirement remains in place even if there is no foreign source income or foreign taxes paid inside the pass-through entity that would lead to any additional foreign tax credit for the eligible partner.

A temporary exclusion for certain domestic partnerships and S corporations

After significant public backlash over the unexpected, pervasive filing requirements included in the final instructions, the IRS issued relief for 2021 by way of an exception for certain domestic partnerships and S corporations for the 2021 tax year. To qualify for the exception, a pass-through entity must meet all of the following qualifications:

• In tax year 2021, the direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates or foreign trusts
• In tax year 2021, the domestic partnership or S corporation has no foreign activity, including foreign taxes paid or accrued or ownership of assets that generate, have generated, or may reasonably be expected to generate foreign source income
• In tax year 2020, the domestic partnership or S corporation did not provide to its partners or shareholders nor did the partners or shareholders request information regarding (on the form or attachments hereto):
  Form 1065 – Line 16, Schedules K and K-1
  Form 1120-S – Line 14, Schedules K and K-1
  Form 1065 – Line 20c, Schedules K and K-1
  Form 1120-S – Line 17d, Schedules K and K-1
• The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021

 If a partnership or S corporation qualifies for this exception, the pass-through entity does not need to file Schedules K-2 and K-3 with the IRS or with its partners or shareholders. However, if the partnership or S corporation is subsequently notified by a partner or shareholder that all or part of the information contained on a Schedule K-3 is needed to complete their tax return, then the partnership or S corporation must provide the information to the partner or shareholder. Also, if a partner or shareholder notifies the partnership or S corporation before its return is filed, the conditions for this exception are not met and the partnership or S corporation must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS. Since partnerships subject to the centralized partnership audit regime (CPAR) must go through the Administrative Adjustment Request (AAR) process, it is advisable to extend these returns so such partners could be accommodated if necessary with an originally filed return.

The exception, as detailed above, is only available for tax year 2021. Domestic partnerships and S corporations will face increased reporting requirements in succeeding tax years absent any further relief being provided (i.e., new de minimis thresholds).

Ineligible entities

Pass-through entities that are not eligible for the preceding relief are required to file Schedules K-2 and K-3 for the 2021 tax year. Entities with either foreign activity and/or foreign owners as well as entities that fail to meet any of the requirements for the exemption listed above must include these schedules as part of a complete return. In order to comply with IRS filing requirements, your Baker Tilly tax advisor may ask for additional information as it pertains to foreign activities and return delivery may be delayed. Failure to prepare and include these schedules as part of the pass-through entity’s tax return could result in different penalties being assessed on a per partner/shareholder basis.

Filing delays

The IRS is not currently prepared to accept Schedules K-2 and K-3 for e-filing at this time. Estimated e-file availability dates vary by form:

• Form 1065 – Projected March 20, 2022
• Form 1120S – Projected mid-June 2022
• Form 8865 – Projected January 2023

Since the anticipated dates occur after the initial filing deadline of March 15, 2022 (for pass-through entities), Baker Tilly recommends all affected entity filings be extended. While the IRS is allowing forms to be completed and uploaded as PDF attachments, this is currently a burdensome process as many files are large and IRS bandwidth is limited.

Looking forward to 2022 filing year

The requirements outlined in the Schedule K-2 and K-3 instructions create an additional filing obligation for many unsuspecting pass-through entities that will go into effect for the 2022 tax year. In the coming months, Baker Tilly will continue to monitor these developments and provide additional information as needed.

We encourage you to connect with your Baker Tilly advisor regarding how the above may affect your tax situation.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.