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The K-2 and K-3 Saga Continues

By Andrew Chong .

International tax information reporting for tax year 2021 adds two new schedules, K-2 and K-3, for pass-through entity tax returns. These schedules were originally intended to only address reporting of items of international tax relevance; however, the new instructions issued in January 2022 required the inclusion of Schedules K-2 and K-3 in many, if not all, pass-through entity returns (including those with only domestic activities and domestic partners). The new instructions could be interpreted to include any situation in which any partner could claim the foreign tax credit on their own returns.

Filing requirements may affect domestic partnerships and S corporations with no items of international tax relevance; however, the IRS has provided seemingly limited filing relief for tax years beginning in 2021.

Background
On June 3, 2021, the IRS released final versions of the new Schedules K-2 and K-3 that are being added to pass-through entity returns for partnerships and S corporations filed for the 2021 tax year:

  • Schedule K-2, Partners’ Distributive Share Items — International
  • Schedule K-3, Partners’ Share of Income, Deductions, Credits, etc. — International

Schedule K-2 reports the entity level activity relating to a pass-through entity return, while Schedule K-3 will be provided to each partner or shareholder to report their proportionate share of each separately stated item. The IRS released draft Schedule K-2 and K-3 instructions on June 30, 2021.

While the intention of the IRS was to introduce a standardized and consistent format of reporting for international tax items, questions remained as to how to comply with the new reporting requirements, considering the tax consequences and administrative ramifications arising from implementation of such substantial and complex reporting.

Good Faith Exception
The detailed 2021 Schedule K-2 and K-3 instructions created transitional challenges. In an effort to ease this transition and the uncertainty around penalties, IRS Notice 2021-39 was released, confirming that it will provide certain penalty relief to filers who fall short of the new requirements in tax years that begin in 2021, if taxpayers make a good-faith effort to comply.

When determining whether a filer has established such an effort, the IRS will consider, among other items:

  • The extent to which the filer has made changes to its systems, processes, and procedures for collecting and processing the information required to file the schedules.
  • The extent the filer has obtained information from partners, shareholders, or a controlled foreign partnership or, if not obtained, applied reasonable assumptions.
  • The steps taken by the filer to modify the partnership or S corporation agreement or governing instrument to facilitate the sharing of information with partners and shareholders that is relevant to determining whether and how to file the schedules.

Concerns From the Tax Community
In January of 2022, the IRS posted updated instructions for the schedules. Under the revised instructions, a pass-through entity may need to report information on the schedules even if it had no foreign partners, foreign source income, assets generating such income, or foreign taxes paid or accrued.

For example, if a partner is eligible to claim a foreign tax credit, the partner may need certain information from the partnership to file his or her income tax return. This update changed the magnitude of the potentially affected taxpayers that are now required to complete new Schedules K-2 and K-3.

There was a substantial concern as it relates to the amount of tax risk and administrative burden involved for purely domestic pass-through entities to complete these cumbersome schedules.

The American Institute of Certified Public Accountants (AICPA) reacted swiftly. Jan Lewis, a chair of the AICPA Tax Executive Committee, spoke at the Senate Finance Committee hearing expressing concerns and challenges regarding the January update to the instructions, as well as the inability to e-file the schedules and the current IRS backlog of unprocessed returns and notices. Thus, the AICPA issued a statement recommending that the IRS delay implementation until 2023 at the earliest.

Due to overwhelming feedback received, the IRS issued new guidance (FAQ #15) on February 16, 2022, which provides additional exceptions to tax year 2021 filing for certain pass-through entities.

The Relief - IRS FAQ #15
The IRS is also providing an additional exception for tax year 2021 for filing the Schedules K-2 and K-3 for certain domestic partnerships and S corporations. To qualify for this exception, the following conditions must be met:

  • The direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts.
  • 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 expect to generate foreign source income.
  • For tax year 2020, the domestic partnership or S corporation did not provide to its partners or shareholders information, nor did the partners or shareholders request the information regarding:
    • Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S)
    • Line 20c, Form 1065, Schedules K and K-1 (line 17d for Form 1120-S).
  • The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021.

Pass-through entities that meet these criteria generally are not required to file Schedules K-2 and K-3. However, there is an important caveat; if a pass-through entity is notified by a partner or shareholder that they need the information included on Schedule K-3 to complete their tax return, the requested information must be provided to the partner. Moreover, if the partner or shareholder notifies the entity of this need before the entity files its own return, the entity no longer satisfies the criteria for the exception, requiring the entity to provide Schedule K-3 to the partner or shareholder and file the schedules with the IRS.

Now What?
It is still unclear as to whether FAQ #15 should be received as a welcomed relief. While it may provide relief for those who qualify, it is important to keep in mind that the current IRS guidance on the exceptions to the Schedules K-2 and K-3 filing requirement explicitly only refers to 2021 tax year filings. Also, it must be emphasized that the reporting must be provided to any partner that requests it. In the absence of further guidance or updates, pass-through entities should expect and be prepared to file the schedules for current and future tax years.

The process of navigating through international tax compliance can be complex and challenging, especially when confronted with continually changing requirements. As these requirements continue to evolve, it is important for pass-through entities to stay informed. Communication with their owners, partners, and tax advisors to assess and determine the best course of action with regard to these filing requirements will be crucial. If you have any questions, reach out to your Citrin Cooperman international tax advisor.

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