February 23, 2022

New Exemptions for Schedules K-2 and K-3 Filers

Many Atlanta S-corporation and partnerships have been confused about the new Schedule K-2 and K-3 filings required as part of the 2021 tax return. Not only does the requirement mean the business and partners/shareholders must report international tax related information on an updated form, but even the type of information required has changed. Despite the fact the updated forms were issued last September, many are unfamiliar with the new filing and concerned about the short adoption timeline. The IRS was aware of the potential for problems and issued IRS Notice 2021-39 which amongst other things offers transitional penalty relief for certain filers. Although helpful, many needed additional time to become familiar and comply with the new requirements. To assuage concern, the IRS announced new exemptions for certain domestic partnerships and S corporations. To help clients, prospects, and others, Wilson Lewis has provided a summary of the key details below.  

New Schedules K-2 and K-3

Domestic partnerships and S-corporations are required to report items of international tax relevance in annual tax filings. Historically, any applicable amounts were reported throughout Forms 1065 or 1120-S with additional statements as needed. This process lacked consistency and added a substantial amount of time for IRS review.

For context, the new schedules K-2 and K-3 originated from the Tax Cuts and Jobs Act, which imposed more calculations and reporting requirements for flow-through entities with international tax obligations. Updating the process of reporting international taxes has already happened on Forms 1040 and 1120; now, Forms 1065 and 1120-S are in the mix.

The new Schedules K-2 and K-3 are meant to streamline and simplify this process. Partners and shareholders will have a clearer view of international tax obligations and the IRS will have an easier time reviewing affected returns. It will also take more time to calculate international tax obligations; however, the goal is increased transparency and compliance.

• Schedule K-2 is an extension of the main tax form (Form 1065 or 1120-S) and replaces line 16a-r, parts of line 20, and additional attached statements.
• Schedule K-3 reports the partner’s or shareholder’s distributive share of international taxes. It replaces line 16, parts of line 20, and additional attached statements.

The IRS said that “The new schedules K-2 and K-3 improve reporting by standardizing international tax information to partners and flow-through investors, making it easier for them to report these items on their tax returns.”

Confusion Follows

Explicit international tax exposure is not the only requirement for filing the new schedules K-2 and K-3. This was one of the biggest sources of confusion when the IRS released its Final Notice.

From the IRS Frequently Asked Questions:

“In many instances, a partnership or S corporation with no foreign partners, foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3. For example, if the partner or shareholder claims the foreign tax credit, the partner generally needs certain information from the partnership on Schedule K-3, Parts II and III, to complete Form 1116. This information should have been reported in prior years, including before the Tax Cuts and Jobs Act, on the Schedules K and K-1, and is information the partner or shareholder needs to compute the foreign tax credit limitation, which determines the amount of foreign tax credit available to the partner or shareholder.”

Other scenarios that could trigger the filing requirement for schedules K-2 and K-3 include:

• The partnership sells personal property and partners are treated as the sellers. Tax impact is recognized based on the partner’s residence. Any gain is reported on schedules K-2 and K-3.
• The S-corporation allocates distributive R&D credits to shareholders. R&D SIC code expenses are reported on schedules K-2 and K-3.
• Individual partners or shareholders can use information reported on schedules K-2 and K-3 to increase the foreign tax credit limitation. Traditional reporting would not have included the business’s interest expense or the tax book value of assets.
• If there is foreign-derived intangible income or the business is subject to the base erosion anti-abuse tax through either a domestic direct or indirect corporate partner.

The IRS has specific examples in FAQ 12.

Transitional Relief for New Reporting Rules

The IRS’s announcement on February 16 that it is allowing a delayed implementation for certain taxpayers is one piece of transitional relief. This includes the news that some businesses are totally exempt from filing schedules K-2 and K-3 for the 2021 tax year. A one-year grace period is extended to businesses that did not have*:

• Direct partners that were foreign partnerships, corporations, individuals, estates, or trusts.
• Any foreign activity, including foreign taxes, paid or accrued, or own any assets that did or could potentially generate foreign income.
• To furnish information to partners or shareholders in 2020 for any of the following:
  • 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).
    • There is no knowledge that partners or shareholders requested or will request that information for the 2021 tax year.

*Applies to the 2021 tax year except where noted

Contact Us

The recently announced changes mean that most Atlanta pass-through entities can breathe a sigh of relief for the 2021 tax filing season. Concurrently, it also serves as an impetus for these companies to become familiar with the new requirements for the next tax season. If you have questions about the information presented above or need assistance with another business tax matter, Wilson Lewis stands ready to assist. To learn more call 770-476-1004 or click here to contact us. Our team looks forward to speaking with you soon.