The IRS provided transitional relief on Wednesday under which qualifying flow-through entities will not have to file new Schedules K-2 and K-3 for the 2021 tax year. The relief is described in Press release IR-2022-38 and Frequently Asked Questions on the IRS website (“Schedules K2 and K3 Frequently Asked Questions” – see FAQ 15).
Relevant partnerships are required to file Schedule K-2, Partners’ Distributive Sharing Elements — Internationaland K-3, Partner’s share of income, deductions, credits, etc. – Internationalwith their Form 1065, Return of partnership income to the United States. The corresponding forms for S corporations to file with their Form 1120-S, U.S. tax return for an S corporationare K-2, Shareholder Pro-Rated Action Items — Internationaland K-3, Shareholder share of income, deductions, credits, etc. – International.
The schedules, new for the 2021 tax year, have been the subject of much commentary among tax practitioners during the current tax filing season, most of them unfavorable. They must be filed by partnerships, S corporations and Form 8865 filers, Return of U.S. Persons under Certain Foreign Partnerships, with “items of international tax significance”, according to their instructions. The potentially broad scope of this rubric and the inherent difficulties in researching and documenting these items have been at the center of much of the frustration expressed by practitioners.
The schedules aim to make these international elements less obscure for partners and shareholders who need information to file their own declarations. In stating this objective, the IRS has previously acknowledged the administrative burden the schedules impose and provided some transitional relief last June, in Notice 2021-39.
The relief announced on Wednesday applies when:
- In the 2021 tax year, the direct domestic partnership partners are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts.
- In the 2021 tax year, the domestic partnership or S corporation has no foreign business, including foreign taxes paid or accrued or ownership of assets that generate, have generated, or may reasonably generate income from a foreign source (see Regs. Sec. 1.861 -9(g)(3)).
- During the 2020 tax year, the partnership or S corporation did not provide its partners or shareholders, nor did the partners or shareholders request, the information on the form or its attachments regarding :
- 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, Sec. 250, Sec. 864(c)(8), Sec. 721(c) partnerships, and Sec. 7874) (line 17d for Form 1120-S).
- The domestic partnership or S corporation does not know that the partners or shareholders are requesting such information for the 2021 tax year.
The IRS said earlier it was taking the plunge “in response to feedback we received from the tax community and our stakeholders.”
The schedules are intended to provide greater clarity to partners and shareholders in calculating their own tax liability with respect to items of international tax significance, in a standardized format. Previously, this information was compiled in a variety of formats that can be difficult for partners to translate, the IRS said. They replace and supplement the often superficial information that previously had to be entered in Schedule K-1, line 16, simply titled “Foreign Transactions”, which then often required an attached document, but without a specified format or information elements.
Additionally, the schedules are intended to help the IRS more effectively verify compliance.
Practitioners may have felt misled when the IRS posted on its website revised instructions for schedules regarding who should file them, said Ed Zollars, CPA, tax partner of Thomas, Zollars & Lynch Ltd. in Phoenix and a speaker and author for Kaplan Accounting Continuing Education, which has written on the issue.
They may have interpreted the previous instruction that partnerships without “items of international tax significance (generally, international activities or foreign partners)” mean that if they have no foreign partners or activities foreign countries, they do not need to file a declaration.
But in a note on a webpage on January 18, 2022, revising the partnership guidance, the IRS said that despite having no foreign source income, no assets generating it, and no foreign taxes paid or accrued, a partnership may still need to file the schedules if, for example, a partner is claiming a foreign tax credit that the partner has paid. Also, even if a partnership has only domestic partners, schedules may be necessary if the partnership has made certain deductible payments to foreign related parties of its partners.
Reviewing all the instructions in this light led to other unpleasant revelations, Zollars said, chiefly the need in many cases to know whether each partner had creditable foreign taxes.
“Just getting this information from each partner would prove inconvenient if the practitioner didn’t prepare partner statements,” Zollars said.
Theirs draft versions released timetables in July 2020. They are lengthy, with the final version of the K-2 partnership spanning 19 pages and K-3 spanning 20 pages (both published in June 2021), and combined instructions spanning 34 pages.
A surprise to many practitioners, aside from the complexity and length of the new schedules, has been the treatment of partners whose foreign or domestic status may not be clear (see Samtoy, “Comply with new Appendices K-2 and K-3“, Tax insider, February 11, 2022). Although the latest statement from the IRS seems to assure them that, without foreign partners, they will be exempt from filing Schedules K-2 and K-3 this year, the difficulty of documenting the domestic status of partners or shareholders may remain.
“Schedules also require a thorough understanding of technical rules that many tax professionals are unfamiliar with,” said John Samtoy, CPA, partner at HCVT in Irvine, Calif., and author of the Tax insider item.
For example, said Samtoy, a practitioner preparing returns for rental real estate partnerships probably never considered whether the partnership’s qualified non-recourse financing interest should be allocated at the partnership level or allocated at the partner level.
“But they’re now being asked to determine that on Schedule K-2 and Schedule K-3,” he said.
Notice 2021-39 provided that, for the 2021 tax year, filers would not be subject to certain penalties if they could demonstrate a good faith effort to comply by modifying their collection systems, processes and procedures. and processing relevant information, including obtaining information from partners, shareholders or a controlled foreign company.
“But the assumption that everyone needed this foreign information was, for partnerships, not optional – so not filing it would not be acting in good faith to try to comply,” Zollars observed.
Meanwhile, tax software producers have struggled to implement a PDF attachment filing option for schedules – which is currently the only method available. The IRS announced in December that it would be ready to accept such data via the modernized e-File electronic filing protocol/extensible markup language by March 20, 2022, for partnerships; mid-June for S corporations; and not before January 2023 for Form 8865 filers (see FAQ #7, on IRS FAQ Web page).
“So when these practitioners checked the status of electronic files in their tax software, in many cases they got these March and June dates, causing panic that virtually all stints would have to be extended,” said Zollars.
Even then, obtaining a filing extension may be the best course of action for Schedule K-2/K-3 filers as the Service continues to assess the situation, Samtoy said.
“I recommend talking to customers to make sure they are aware of the requirements and guidelines that have been issued so far,” he said. “I would also consider filing extensions so clients and preparers have time to consider any exceptions or relief the IRS may announce.”
— To comment on this article or suggest an idea for another article, contact Paul Bonner at [email protected].