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IRS updates partnership international tax reporting

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Business people having video conference in conference room The IRS released updated draft instructions and penalty relief on June 30 for implementing new international reporting requirements for pass-throughs with international operations or foreign partners. The new reporting will be required on Schedules K-2 and K-3 for Forms 1065, 1120-S, and 8865 for tax years beginning in 2021, but the IRS released limited penalty relief under Notice 2021-39.

The updated draft instructions make important changes and provide valuable insight into the future of reporting for international tax matters for pass-through entities. Taxpayers should use the release of the updated draft forms and accompanying instructions as an opportunity to assess their ability to prepare and furnish the required information and to initiate any potential required changes to their tax compliance processes.

Background The IRS first released drafts of Schedule K-2 and K-3 and their accompanying draft instructions in May 2020 in an attempt to better align the tax information pass-through filers provide their partners or shareholders and increase clarity for partners or shareholders on how to compute their U.S. income tax liability with respect to international tax matters. The IRS updated the draft versions of the forms in April 2021 before releasing updated draft instructions on June 30, and is still requesting comments before finalizing the forms and instructions.

The proposed forms are meant to replace, supplement, and clarify parts of the existing international tax reporting sections in Schedule K and Schedule K-1 to Form 1065, Form 1120-S, and Form 8865. Schedules K-2 and K-3 will be attached to the pass-through filer’s return (i.e. Form 1065, Form 1120-S, or Form 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 forms 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 filers are already providing to their partners or shareholders. Standardizing this process is intended to streamline tax reporting for stakeholders of pass-through entities.

Implementation considerations In general, the instructions for tax years beginning for 2021 for certain parts of the Schedules K-2 and K-3 require certain pass-through filers to report information unless the pass-through filer has reason to know that the information is not relevant to its partners, shareholders or indirect partners.

Schedule K-2 requires pass-through filers to report a wide range of information about its operations that is potentially relevant in applying various international tax provisions at the partner or S corporation shareholder level, including:

  • Current-year international transactions
  • Foreign tax credit limitations
  • Information to complete Form 8621

Pass-through filers required to file Schedule K-2 will attach the schedule to their federal tax returns. Schedule K-3 is intended to operate in a manner similar to Schedule K-1 in the sense that it is completed for, and delivered to, each partner or shareholder and reflects the partner’s or shareholder’s allocable share of the international tax items that the pass-through filer reports on the Schedule K-2.

Grant Thornton Insight: The proposed changes may present challenges to partnerships and S corporations with foreign operations and investments, including asset management funds and private equity funds. While the IRS is providing penalty relief for certain pass-through filers during tax years beginning in 2021, taxpayers should immediately evaluate how these changes will impact them.
The IRS is soliciting comments concerning the draft instructions to Schedules K-2 and K-3. Specifically, the IRS is seeking examples of instances in which filers may need to rely on reasonable assumptions in determining whether and how to complete Schedules K-2 and K-3 for years after the transition period and whether these assumptions may differ between various parts of the Schedules K-2 and K-3.

Transition relief Notice 2021-39 provides transition relief for taxable years that begin in 2021, stating that filers will not be subject to penalties with respect to new Schedules K-2 and K-3 for Forms 1065, 1120-S, and 8865, provided certain conditions are satisfied. 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. A filer who meets this good faith effort standard during for the 2021 tax year will not be subject to the relevant penalties described in the notice for any incorrect or incomplete information. Penalties for which relief may be provided include:

  • Section 6698 (failure to file or show information on partnership return)
  • Section 6699 (failure to file or show information on S corporation return)
  • Section 6722 (failure to furnish correct payee statements)
  • Section 6038(b) and (c) (penalties for failure to furnish information on foreign business entities)

Notice 2021-39 provides some detail about the factors that will be considered in determining whether a filer made a good faith effort in filing a Schedule K-2 or K-3. Some relevant factors include:

  • The extent to which the filer has made changes to its systems, processes, and procedures for collecting and processing information relevant to filing the Schedules K-2 and K-3
  • The extent to which a Schedule K-2 and Schedule K-3 filer has obtained information from partners, shareholders, or the CFP, or applied reasonableness of assumptions when information is not included
  • The steps the filer has taken to modify pass-through agreements or governing instruments to facilitate the sharing of information with partners and shareholders.

The IRS will consider the efforts made by the filer, including its diligence and the reasonableness of assumptions made in completing Schedule K-2 or Schedule K-3. The reasonableness of a filer’s assumptions may depend on the relationship between the Schedule K-2 or Schedule K-3 filer and its partners or shareholders. For example, a partner that manages or controls a partnership may be able to obtain information more easily as compared to partners holding small interests in the partnership.

Accordingly, a Schedule K-2 and K-3 filer should make every effort to ensure the accuracy of the information obtained from its partners or shareholders in order to appropriately report the applicable international tax reporting information for the 2021 tax year.

Next steps Forms Schedule K-2 and Schedule K-3 and the accompanying instructions are still in draft form and the IRS could make changes before they are finalized. Once finalized, these updated reporting requirements could significantly increase the federal income tax compliance burden for pass-through filers with foreign operations or foreign partners, depending on their circumstances. Pass-through filers should take the opportunity to assess their compliance processes now in order to mitigate any costs associated with the transition to reporting using Schedule K-2 and K-3. Pass-through filers may also want to revise their compliance timeline and deadlines associated with providing tax information to their applicable partners or shareholders.

For more information, contact:
David Sites
National Managing Partner, International Tax
Washington National Tax Office
Grant Thornton LLP
T +1 202 861 4104

Buck Buchanan
Managing Director, IRS Practice and Procedures
Washington National Tax Office 
Grant Thornton LLP
T +1 404 704 0146

Whit Cocanower
Manager, Partnership Tax
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1541

Grace Kim
Principal, Partnership Tax
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1590

Cory Perry
Senior Manager, International Tax
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1509

Olivia Arnold
Manager, International Tax
Washington National Tax Office
Grant Thornton LLP
T +1 678 515 2490
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