The IRS on Feb. 16, 2022, posted a list of frequently asked questions (FAQs) to its website, providing additional filing relief for certain domestic pass-through entities that may be subject to the new Schedules K-2 and K-3 reporting requirements.
The additional transition relief from the Schedules K-2 and K-3 reporting applies to domestic pass-through entities that have no foreign activities, no foreign partners or shareholders, and which lack knowledge of any partners or shareholders requesting information regarding items of international relevance. For 2021, these qualifying domestic partnerships and S corporations will not have to file the new schedules.
The new exception was created as a response to extensive feedback from taxpayers and practitioners about the breadth of the new reporting requirements. Although the guidance provides welcome relief for many taxpayers, it is limited in scope. The new Schedules K-2 and K-3 will still impose a significant burden for many 2021 pass-through returns. The background on Schedules K-2 and K-3 reporting, and details on the requirements necessary to qualify for the new exception, are described below.
The IRS first released drafts of Schedules K-2 and K-3 and their accompanying draft instructions in May 2020. They were intended to better align the tax information pass-through entities provide their investors and increase clarity for investors on how to compute their U.S. income tax liability with respect to international tax matters. The IRS provided various draft versions before releasing “final” instructions and forms in September 2021. These “final” versions were subsequently modified by updates released last December, January and this month.
The Schedules K-2 and K-3 are meant to replace, supplement, and clarify parts of the existing international tax reporting sections in Schedules K and K-1 to Forms 1065, 1120-S, and 8865. Schedules K-2 and K-3 will be attached to the pass-through entity’s return (i.e., Forms 1065, 1120-S, or 8865) while Schedule K-3 will also be delivered to the partners or shareholders in the same manner and timing as Schedule K-1. These schedules provide a standardized format for reporting applicable U.S. international tax information. The IRS has stated that the information required on the new schedules is expected to be information that pass-through entities are already providing to their investors.
In addition, the IRS released limited penalty relief under Notice 2021-39. Transition relief is available to filers that establish “to the satisfaction of the Commissioner” that they made a good-faith effort to comply with the new reporting requirements. For more coverage on these reporting requirements and Notice 2021-39, see our prior story, “IRS updates partnership international tax reporting.”
The IRS on Jan. 18, 2022, introduced post-release changes specific to the Schedules K-2 and K-3 instructions for all pass-through entities. For the most part, the changes provided welcome clarifications and exceptions to aspects of the reporting requirements. However, the IRS clarified that entities with no foreign activities or investors may still need to complete parts of Schedules K-2 and K-3 due to investors claiming foreign tax credits or other needs unless the pass-through entity has sufficient information that none of its direct or indirect investors need such information.
As a result of feedback from stakeholders on the breadth of the potential reporting, the IRS provided additional relief for certain domestic pass-through entities within updated FAQs regarding the Schedules K-2 and K-3. FAQ #15 was added on Feb. 16, which provides a filing exception for certain domestic partnerships and S corporations that meet the following requirements:
- 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 source income (see Treas. Reg. sec. 1.861-9(g)(3)).
- 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) both:
- 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, Form 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.
Per the FAQs, pass-through entities that qualify for this exception do not need to file Schedules K-2 and K-3 with the IRS or with their investors. However, if a pass-through entity 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, then the pass-through entity must provide the information to the partner or shareholder. If a partner or shareholder notifies the partnership or S corporation before the partnership or S corporation files its return, the conditions for the exception are not met and the partnership or S corporation must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS.
Although Question 15 of the FAQs brings welcome relief to certain pass-through entities, it does not provide blanket relief to pass-throughs. The exception is currently limited to pass-through entities that meet the applicable requirements for tax year 2021. Further, if a pass-through entity had already undertaken efforts to communicate with their partners—as required in the final versions of the instructions—and were notified that a partner needs certain information required to be reported on Schedule K-3, the entity would not be eligible for relief under this new exception.
Affected domestic pass-through entities should take the opportunity to assess their investors’ information needs and their knowledge of such needs and evaluate whether the new exception may apply to these circumstances.