In an effort to offer greater relief for certain pass-through entities which had been required to file the new Schedules K-2 and K-3 tax forms for 2021, the IRS announced in February 2022 that certain domestic partnerships and S corporations may now no longer be obligated to file the new schedules. This announcement is designed to provide relief from the administrative burden that preparing and submitting Schedules K-2 and K-3 placed on pass-through entities and their service providers.
Requirements for Filing the New Schedules K-2 and K-3
For items of international tax relevance, provisions of the Tax Cuts and Jobs Act of 2017 require taxpayers to provide significantly more information in order to calculate their U.S. tax liability. Schedule K-2 reports these items, while Schedule K-3 allows for reporting of a partner’s distributive share of these items. With the addition of the new Schedules K-2 and K-3, portions of Schedule K and many other unformatted statements which needed to be attached to earlier versions of Schedule K-1 have been essentially eliminated.
In general, Schedules K-2 and K-3 must be filed with a partnership’s Form 1065 (“U.S. Return of Partnership Income”) or an S corporation’s Form 1120-S (“U.S. Income Tax Return for an S Corporation”). Previously, partners and S corporation shareholders could obtain the information that’s included on the schedules through various statements or schedules the respective entity opted to provide, if any. The new schedules K-2 and K-3 require pass-through entities to provide more detailed and complete reporting than they may have been accustomed to submitting, in the past.
In January of 2022, the IRS surprised many in the tax community when it posted changes to the instructions for the schedules. Under the revised instructions, an 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.
If a partner claims a credit for foreign taxes paid, for example, the partner might need certain information from the partnership to file his or her own tax return. Although some limited exceptions apply, this change significantly expanded the number of taxpayers required to file the schedules.
The Good Faith Exemption
With the release of IRS Notice 2021-39, affected taxpayers received an exemption from penalties for the 2021 tax year if they made a good faith effort to comply with the filing requirements for the new Schedules K-2 and K-3. In determining whether or not a filer has made a good faith effort, the IRS considers, among other things:
- 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 to which the filer has obtained information from partners, shareholders, or a controlled foreign partnership or, if not obtained, applied reasonable assumptions; and
- 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’s relevant to determining whether to file the schedules and how to do so.
If it determines the taxpayer exercised good faith efforts, the IRS won’t impose the penalties associated with any incorrect or incomplete reporting on Schedules K-2 and K-3.
The IRS’ February 2022 changes afford partnerships and S corporations the leeway not to file Schedules K-2 and K-3 if they satisfy all of the following requirements:
For the 2021 Tax Year:
- The direct partners in the domestic partnership aren’t foreign partnerships, corporations, individuals, estates, or trusts.
- The domestic partnership or S corporation has no foreign activity, including 1) foreign taxes paid or accrued, or 2) ownership of assets that generate, have generated, or may reasonably be expected to generate foreign-source income.
For the 2020 Tax Year:
- The domestic partnership or S corporation didn’t provide its partners or shareholders — nor did they request — information regarding any foreign transactions.
- The domestic partnership or S corporation has no knowledge that partners or shareholders are requesting such information for the 2021 tax year.
For the most part, entities which meet these criteria aren’t generally required to file the new Schedules K-2 and K-3, with one important exception. If a partnership or S corporation is notified by a partner or shareholder that it needs all or part of the information included on Schedule K-3 to complete its tax return, the entity must provide that information.
In addition, 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. As a result, it must provide Schedule K-3 to the partner or shareholder and file the schedules with the IRS.
The IRS guidance on the exceptions to the Schedules K-2 and K-3 filing requirement refers explicitly to tax year filings for 2021. In the absence of additional or updated guidance, partnerships and S corporations should prepare to file the schedules for current and future tax years in accordance with current filing deadline guidelines.
If you need assistance in determining whether or not you will need to file the new Schedules K-2 and K-3 or in understanding the most recent IRS changes and guidance around these schedules, please contact your Untracht Early advisor.