Change to Schedules K-2, K-3 filing instructions affects pass-through entities
New instructions for Schedules K-2 and K-3 expanded international reporting requirements to many U.S. pass-through entities that might not have international operations. Additional guidance has provided some protection for 2021, but there’s still a lot to learn.
The Internal Revenue Service (IRS) released modified instructions in January for a new form that pass-through entities (PTEs) will use, starting with their 2021 information returns, to report international activities to partners and shareholders, as well as the federal government. Taxpayers and tax professionals assumed, based on previous drafts of the instructions for the new forms, that only those PTEs with international activities or non-U.S. owners would be required to file the new Schedule K-2, Partners’ (or Shareholders’) Distributive Share Items — International, and K-3, Partners’ (or Shareholders’) Share of Income, Deductions, Credits, etc. — International. The January changes required PTEs with only U.S. operations to complete the forms if a partner or shareholder might be claiming a foreign tax credit or had to report items relevant to international tax matters, even if the PTE itself had no international activity.
The January changes required PTEs with only U.S. operations to complete the forms if a partner or shareholder might be claiming a foreign tax credit.
This significant expansion of the reporting obligations, timed as it was within days of the opening of the 2021 tax filing season, caused concerns about the ability of PTEs to comply with the new rules. Those entities with known foreign activities or non-U.S. equity owners were generally aware of the expanded reporting rules, and many had taken steps to prepare. But U.S.-based entities with no known non-U.S. equity owners and no foreign operations had been led to believe that the rule change wouldn’t affect them. Suddenly, after the close of the December 31 tax year, it became clear that any direct or indirect equity owner claiming a foreign tax credit could trigger the expanded reporting requirements.
Limited protection for those filing Schedules K-2 and K-3 for 2021
PTEs that fail to file accurate information reports can be subject to a variety of penalties. The IRS has stated that entities that are required to file Schedules K-2 and K-3 for tax year 2021 can avoid penalties for incorrect or incomplete Schedule K-2 or K-3 reporting if they can establish that they made a “good faith effort” to comply with the instructions.
To determine if a PTE made a good-faith effort, the IRS will consider:
- The extent to which the PTE made changes to its systems, processes, and procedures for collecting and processing relevant information.
- The extent to which the PTE obtained information from partners or shareholders, or applied reasonable assumptions when information is not obtained.
- Any steps taken by the PTE to modify its governing instrument to facilitate the sharing of information with partners and shareholders that’s relevant to determining whether and how to file Schedules K-2 and K-3.
New guidance offers a one-year safe harbor for K-2 and K-3 filings
In addition to the good-faith efforts protection from penalties, and in response to significant pressure from taxpayers and tax professionals, the IRS announced a one-year safe harbor for some PTEs that might otherwise have been required to file Schedules K-2 and K-3 for 2021. To qualify for this exception, a PTE must meet all of the following conditions:
- 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-sourced 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 the information regarding (on the form or attachments thereto):
- Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S).
- Line 20c, Form 1065, Schedules K and K-1 (Controlled Foreign Corporations, Passive Foreign Investment Companies, 1120-F, section 250, section 864(c)(8), section 721(c) partnerships, and section 7874) (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.
The IRS announced a one-year safe harbor for some PTEs that might otherwise have been required to file Schedules K-2 and K-3 for 2021.
This may be a tight exception for some PTEs to fit through but could provide a one-year reprieve to some of the U.S.-based PTEs that didn’t find out they were covered under the new rules until January of this year. The exception must be considered carefully in the context of previously issued guidance and was included in a list of Frequently Asked Questions (FAQs) also added to the IRS website on Feb. 16, 2022.
Moreover, the exception doesn’t apply if a partner or shareholder subsequently notifies the PTE that some or all of the information contained on Schedule K-3 is required in order for them to complete their return. Should that occur, the PTE must provide the information, and if the PTE has not yet filed its return, Schedules K-2 and K-3 must be prepared and also submitted to the IRS.
The FAQ is void as to what a PTE should do if the return has already been filed with the IRS. Partnerships may have limited options, in this case, due to onerous rules that can prevent the filing of an amended return for certain PTEs. Therefore, partnerships may be well advised to extend their returns so that the possibility of filing a superseding return is an option. Finally, partnerships with large numbers of partners or included in a tiered partnership structure may wish to consider the administrative burdens that could arise from reliance on the exception only to have requests for Schedule K-3 information come in long after the return has been filed or Schedule K-1s issued.
Long-term positives and negatives of Schedules K-2 and K-3
While there’s always some concern about adding new reporting requirements for any business or investment, the goal of the IRS changes here is not all bad. The Schedules K-2 and K-3 could bring more consistent reporting to what had previously been shared with investors on Line 16 of the Form K-1 as “Foreign Transactions.” Reporting in the old form could vary widely based on the information shared with the tax preparer and the individual firm’s practices for disclosure in this area. Investors who rely on this information to file an accurate tax return will likely benefit in the long term from seeing a more consistent report that allows for more accurate tax reporting and more effective comparison between investments. However, that doesn’t make the growing pains that accompany the implementation of a new requirement like this any easier to take.
To learn more about how these late modifications in the international reporting process for pass-through entities could affect your 2021 information returns, please contact your Plante Moran advisor.