Penalty Relief Announced for Partnerships and S Corporations for 2021

For partnerships and S corporations with tax years that begin in 2021, the IRS has announced penalty relief in Notice 2021-39 for certain failures related to the filing of new Schedule K-2 (Partners’ Distributive Share Items—International) and Schedule K-3 (Partner’s Share of Income, Deductions, Credits, etc.—International). These schedules, which are a required part of Form 1065 (U.S. Return of Partnership Income), Form 1120-S (U.S. Income Tax for an S Corporation) and Form 8865 (Return of U.S. Persons with respect to Certain Foreign Partnerships) filings, were developed to provide partners and shareholders with more transparency on items of international tax relevance, including claiming deductions and credits. The new schedules are also intended to allow the IRS to more efficiently verify tax compliance on international tax matters.

As IRS examinations of pass-through entities continue to increase, it is essential to become familiar with the new Schedules K-2 and K-3 reporting requirements and begin taking steps to compile the necessary information for compliance with these new rules.

Applicable Penalties

Under current law, the following significant penalties may be imposed on a partnership or S corporation for failure to file a correct or complete Schedule K-2 or K-3. Each of these penalties may be eligible for abatement if a taxpayer can successfully demonstrate that the failure was due to reasonable cause.

1. Failure To File or Show Information on a Partnership Return (IRC Sec. 6698)—For partnership taxable years beginning in 2021, a return for purposes of IRC Sec. 6698 includes Form 1065, Schedule K-1 (Form 1065), and Schedules K-2 and K-3. Currently, the penalty imposed on the partnership is calculated at $210 per partner per month that the return is late or incomplete, for a maximum of 12 months.
2. Failure To File or Show Information on an S Corporation Return (IRC Sec. 6699)—For S corporation taxable years beginning in 2021, a return for purposes of IRC Sec. 6699 includes Form 1120-S, Schedule K-1 (Form 1120-S), and Schedules K-2 and K-3. Currently, the penalty imposed on the S corporation is calculated at $210 per shareholder per month that the return is late or incomplete, for a maximum of 12 months.
3. Failure To File Correct Information Returns (IRC Sec. 6721)—IRC Sec. 6721 imposes a penalty for any failure to file an information return on or before the required filing date, and for any failure to include all of the information required to be shown on the return or the inclusion of incorrect information. Form 1065 and each schedule with respect to each partner attached to Form 1065 is considered a separate information return subject to this penalty. Failure to electronically file a correct information return would generally subject a partnership to a penalty under IRC Sec. 6721. Currently, this penalty is imposed at up to $270 per failure.
4. Failure To Furnish Correct Payee Statements (IRC Sec. 6722)—IRC Sec. 6722 imposes a penalty for failure to furnish a payee statement on or before the date prescribed, and for any failure to include all of the information required to be shown on the payee statement or the inclusion of incorrect information. A payee statement includes a statement required to be furnished to each partner in a partnership and each S corporation shareholder. Currently, this penalty is imposed at up to $270 per failure.
5. Failure To Furnish Information Required by IRC Sec. 6038 Related to Form 8865—For partnership taxable years beginning in 2021, penalties will be imposed for failure to furnish information on Form 8865, Schedule K-1 (Form 8865) and Schedules K-2 and K-3. Form 8865 is used to alert the IRS to reportable transactions with a controlled foreign partnership (“CFP”). To be a CFP, the U.S. person must own more than a 50% interest in the partnership.

The penalty under IRC Sec. 6038 is significant at $10,000 per failure, with a continuation penalty of $10,000 for each 30-day period beginning 90 days after notification from the Internal Revenue Service about the failure (such continuation penalty not to exceed $50,000).

Transition Penalty Relief Under Notice 2021-39

Notice 2021-39 provides transition penalty relief to partnerships and S corporations for tax years that begin in 2021 with respect to Schedule K-2 and Schedule K-3 to Forms 1065, 1120-S, and 8865. During this transition period, a partnership required to file Form 1065, an S corporation required to file Form 1120-S, and a U.S partner required to file Form 8865 (each defined as a “Schedule K-2/K-3 filer”) will not be subject to the above penalties for any incorrect or incomplete reporting on Schedules K-2 and K-3 if it can demonstrate a good faith effort to comply with the Schedules K-2 and K-3 filing (and furnishing) requirements.

To determine “good faith effort” to complete Schedules K-2 and K-3, the IRS will take into account the extent to which the Schedule K-2/K-3 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. In addition, the IRS will examine the extent to which the Schedule K-2/Schedule K-3 filer has obtained information from partners, shareholders, or the CFP, or applied reasonable assumptions when information is not obtained. The IRS will also look to steps taken by the Schedule K-2/K-3 filer to modify the partnership or S corporation agreement or governing instrument to allow for information sharing with partners and shareholders that is relevant to determining whether and how to file Schedules K-2 and K-3.

According to the Notice, the appropriate level of diligence and/or reasonableness of an assumption may be different for a partner that manages or controls the partnership or a partnership with a partner with a significant interest in the partners, such as a partner with a 10% interest, as compared to partners holding small interests without the same easy access to information. The Notice makes clear that a filer that does not establish that it made a good faith effort to comply with the new requirements will not be eligible for penalty relief.

Earlier this year, the IRS announced transition penalty relief in Notice 2021-13 for partnerships with 2020 Schedule K-1 reporting failures that are able to demonstrate ordinary business care and prudence. In addition to the penalties addressed above, Schedule K-1 transition relief includes relief from the 20% accuracy related penalty under IRC Sec. 6662 for the portion of an imputed underpayment (under the centralized partnership audit regime) attributable to an adjustment to a partner’s beginning capital account balance reported by the partnership for 2020, to the extent the adjustment arises from the inclusion of incorrect information. New Notice 2021-39 does not address how Schedule K-2 and K-3 penalty relief would apply to an adjustment to a partnership return under the centralized partnership audit regime and does not provide relief from the 20% accuracy related penalty.