Most Schedule K-2 and K-3 Reporting Can Now Be Postponed Until 2022 Tax Return Filing

The IRS just announced that it is providing transition relief from Schedule K-2 and K-3 reporting for certain domestic partnerships and S corporations with no foreign activities, foreign partners or shareholders, and for those without knowledge of partner or shareholder need for information on items of international relevance. For 2021, these qualifying partnerships and corporations will not have to file the new schedules.

Schedules K-2 and K-3: Background

The Tax Cuts and Jobs Act, passed in December 2017, brought major reform to U.S. international tax. To implement the changes, the IRS introduced a new filing requirement for passthrough entities – Schedules K-2 and K-3 – starting in tax year 2021. The schedules were added to further enhance Schedule K-1 foreign reporting. 

Originally, a partnership was only required to provide Schedules K-2 and K-3 if it had operations with international tax relevance, which includes international activities, foreign partners with reporting obligations or withholding tax. But with its announcement on January 18, the IRS expanded original guidance, requiring passthrough entities to file schedules K-2 and K-3 unless they could determine that all of their partners or shareholders did not have to file Form 1116 (foreign tax credit form for individual taxpayers). This requirement added significant burden and additional paperwork for many partnerships and S corps with only U.S. activities. Consequently, many taxpayers and preparers complained about the greatly increased reporting requirements that contained minimal tax impact. 

The IRS February 16 announcement

When the IRS became aware of the concerns, it provided an exception for tax year 2021, via an announcement on February 16. Specific requirements are:

  • 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 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 the information regarding (on the form or attachments thereto):
    • Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S), and
    • 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.

If a partnership or S corp qualifies for this exception, it does not need to file Schedules K-2 and K-3 with the IRS or with its partners or shareholders. But if the partnership or S corp is subsequently notified by a partner or shareholder that all or part of the information contained on Schedule K-3 is needed to complete their tax return, the partnership or S corp must provide the information to the partner or shareholder. Conversely, if a partner or shareholder notifies the partnership or S corp before the partnership or corporation files its return, conditions for the exception are not met and the partnership or S corp must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS.

The February 16 announcement is certainly welcome news for many tax practitioners and purely domestic passthrough entities. For additional details about Schedules K-2 and K-3, contact your Schneider Downs advisor.

 

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