Beginning in tax year 2021, partnerships, S corporations, and US persons who were partners in foreign partnerships or entities electing to be taxed as partnerships will be required to submit the new Schedule K-2 and K-3 with their returns if they have items of “international tax relevance.”
The new schedules and instructions are intended to assist pass-through entities with reporting specific US international tax information to domestic and foreign Schedule K-1 recipients. The IRS hopes that these new tax forms will make it easier for taxpayers to compute and report their US income tax liability and to enforce cross-border tax compliance.
What are Schedules K-2 and K-3 and Who Must File?
The new Schedules K-2 and K-3 report each partner’s or shareholder’s distributive share of international income, deductions, and credits. These schedules replace, supplement, and clarify the foreign reporting that was formerly included on Schedules K and K-1. The Schedule K-2 is filed with the pass-through entity tax return and the Schedule K-3 is distributed to partners or shareholders. All pass-through entities must submit the new schedules for all relevant items of international tax consequence.
Filing Schedules K-2 and K-3 is required for filers of Form 1065, Form 1120S, and Form 8865 who transacted cross-border activities and had foreign investments, owners, or income. Pass-through entities without international activities or foreign partners are generally not required to file the new schedules; however, the IRS recently released changes to the forms’ instructions that greatly expand the filing requirements for certain partnerships even if the partnership has no foreign activities and foreign partners. For example, a partnership having no foreign source income and no foreign partners may be required to file Schedules K-2 and K-3 if it has partners who claim a foreign tax credit from unrelated sources of foreign income. Be on the lookout for changes to Schedules K-2 and K-3 instructions and Schedule K-2 and K-3 forms this tax season.
What Prompted the Development of Schedules K-2 and K-3?
Private equity and alternative asset management firms, including hedge funds, real estate funds, energy funds, and venture capital firms have used a variety of forms and schedules to report international tax information to their investors. Schedules K-2 and K-3 aim to make reporting more straightforward and standardized while reducing the costs of preparing tax forms.
The IRS has offered relief for taxpayers transitioning to the new Schedules K-2 and K-3. For the tax year beginning 2021, the IRS will not levy certain fines if the filer can show to the IRS’ satisfaction that it made a good-faith effort to comply with the new reporting requirements or to Notice 2021-39.
International Tax Relevance
As stated previously, Schedules K-2 and K-3 apply to filers of Forms 1065, 1120-S, and 8865 to report items of international tax relevance. These items include:
- Foreign tax credits – This can include related information, such as the sourcing and category of income and deductions like R&E and interest expenses.
- Interests in foreign entities – Any payments or distributions from foreign corporations.
- Foreign partner’s US source income and effectively connected income – This can include the distributive share of deemed sale items on the transfer of a partnership interest.
- Investments in foreign entities – like passive foreign investment companies.
- Any interests in controlled foreign corporations.
- GILTI and Subpart F income
- Foreign-derived intangible income
What to Know about Partnerships, Fund managers, and S Corporations
The new schedules will add a significant reporting burden for partnerships and S corporations with international reporting requirements. The forms are lengthy, necessitating a thorough knowledge of advanced international tax topics. Working with an international tax preparation expert helps ensure that all information is accurate and no forgotten detail causes penalties or complications.
The new reporting obligation presents a significant challenge for firms having to report international information on the new schedules. Investment funds are likely concerned about additional detail in the new schedules, investor-relations difficulties, and timing issues associated with distributing the different tax forms, including Schedule K-1 and K-3.
Shareholder and Partner Impact
Shareholders and partners will be receiving the new Schedule K-3 in addition to Schedule K-1. The new standardized format, which includes information on things like the foreign tax credit (FTC) and passive foreign investment companies (PFICs), should help alleviate some of the compliance problems for taxpayers. That will be especially useful for investors who hold interests in several pass-through businesses during tax season when they have minimal time to do their taxes.
Partners and S corporation shareholders should compare the new Schedule K-3 with the previous year’s Schedule K-1 for any changes or additional data. It is wise to double-check if information was inadvertently omitted from a prior year Schedule K-1 that may result in amendments to prior year tax returns and/or correcting carryforward records.
Partnerships, S corporations, and filers of Form 8865 should prepare for the upcoming filing requirement by confirming foreign activities of their partners, reviewing 2021 transactions, and determining what information may be required to file Schedules K-2 and K-3.
Contact Windes’ Tax experts if you have questions regarding Schedule K-2 or K-3 filing rules or other questions about your international partnership interests. Windes is available to help international entities navigate the new Schedule K-2 and K-3 documents for a sound tax strategy.