How to Read & Prepare Schedule K-2/3
Learn the basic understanding of each part of Schedule K-2/3 and know when each section is required to be completed.
Edo Pollack: Hi, everybody. Good afternoon, or good morning if you're in the U.S. Coming to you live from our Israel office in Tel Aviv. EisnerAmper is a top-tier U.S. accounting firm with offices across the U.S. We have a 4,000 strong professional team. The team here in Israel is just over 20 members and growing, thank God, so looking forward to that. Our focus here is on financial services, primarily servicing venture capital funds, private equity funds, hedge funds, real estate funds. The firm also covers plenty of startups, corporate type entities, as well as high net worth individuals, family offices. We're really excited to be offering one of, if not the first, CPE session of 2024 to give everyone a nice jump on their compliance. The topic that today is going to cover, the Schedule K-2/K-3, it's an issue which is still developing, so we felt it would be apropos to revisit now before we get back into this tax season and start preparing all these forms yet again. But enough of me. And now for the star of the show, our returning champion of everything international. I'm really happy to introduce our very own tax director, Ayelet Duskis.
Ayelet Duskis: Hello everybody. It's really nice to be back and to talk about a topic that is extremely complicated and difficult but interesting at the same time. One of the things that I found most interesting about this class was that we originally were marketing this CPE session for the Israeli CPA... U.S. CPA audience, and I saw that there was a lot of people that came on that are not from that audience, and it just gave me a second to pause as I realized that we're in year three now. We're going into year three of having this Schedule K-2/K-3 as part of our 1065s and 8865s, and we're still pretty confused. There's still a lot of unclarity. Is that a word? It's still not quite straightforward, what's going on, or which sections we need to fill, or if a section is full, is it relevant to me? What do I need to take from that to report on my client's tax return?
And so, we're putting ourselves in a little bit of an interesting spot going into year three and still maybe having some more clarity than we had in year one, but by far with a lot still to learn. I believe the IRS still has a lot to learn about this as well. They try to make an attempt to put together these forms, and I'll show you a few places where I find it inconsistent with maybe what their main goals were. Today, we're going to talk about a little bit of what the purposes of the Schedule K-2/K-3 are, when they're required. We're going to go through each part of the form, who needs to report each part of the form... in each section of the form, what it means, and then a quick summary.
So, we'll get started right away. So the Schedule K-2/K-3 came out in 2021, or for the 2021 tax season. The combined instructions of the Schedule K-2/K-3 are forty-five pages long, and the actual form itself is maybe 20 pages, 25 pages long. So, our K-1s went from being a three-page thing that we'd send to the partners to being pages and pages long. And on the flip side, when we're receiving K-1s as tax preparers, we're receiving a massive pile of information now. The K-2/K-3 was also added to the Form 8865. On the 8865, the instructions are only 26 pages long, so they're a little bit less, but it is still equally as complicated. The K-2 specifically is meant to be an extension of the Schedule K, so the K-2 is on the partnership level. The K-3 is on the partner level.
Interestingly enough, not everything that you have to complete on the K-2, which is going to be on the full partnership level, is going to be relevant for every single partner that receives the K-3. So, on the K-2, you'll do the full partnership numbers, but you might not foot if you add all the K-2s together, because there may be a section that only a few partners are going to receive, and for everybody else, it's going to be blank. So, that's an interesting, very, very large difference from a Schedule K versus a Schedule K-1.
The main goal of the IRS here was uniformity, clarity, transparency. They want everything to look the same. They want to make sure that as a partner receiving the K-1, the partner is able to digest the information and report it properly. From their perspective, they wanted clarity. They wanted transparency. They wanted to make sure that nothing's getting hidden. More of all that stuff that since back on 2010 we've been fighting with, so to speak, of trying to make sure that everything is clear and over the table, and so this is just another level of that, making sure every piece of information has been reported to the IRS. Nothing is hiding. This took away the old Line 16 from the Schedule K-1, as well as a lot of the footnotes that we used to have, or a lot of the extra supplemental information.
The instructions to the K-2 say you only have to complete the sections that are relevant to the partnership. So, the first time I ever read the instructions, which was back in 2021, I was about eight months pregnant at the time, and I remember thinking, like, "Oh, my God, the IRS is being reasonable." And I was very excited., because I was like, "Wow, we only have to put what's relevant for us today." But then, I started reading the instructions more in depth, and I realized that the IRS's definition of relevant and Ayelet Duskis's definition of relevant are not the same. And they're not asking me what I think is relevant. They're telling you, "You only have to complete what's relevant, and we're going to tell you what's relevant."
So, it's not quite as reasonable as we would expect, and it has definitely added a huge... As a person that it prepares K-2s and K-3s on a regular basis, it's added a huge workload to our tax preparers, and as a person that receives the K-1, it's also added a massive burden. And so, there's definitely that reasonableness... I don't necessarily think that necessarily the IRS has been so reasonable, but it is very important that we keep in mind as we're going through the forms that we can't rely on our own definition of relevant. We have to look to the instructions to the form, and we have to understand if the IRS views this as relevant, not if we view this as relevant.
If the K-3 is not prepared properly, the partnership could be subject to penalties. Year one, the IRS said that they won't give any penalties, so we all kind of went through a deep sigh of relief. Year two, I personally haven't seen any penalties because the K-2/K-3 wasn't prepared properly. I don't know how the IRS would figure out if there was mistakes or not, but it's definitely... What I see is a lot of caution. I see people trying to complete more rather than complete less in the hopes of not being caught, like, "Oh, you should have done this section, and you didn't, and now your client is going to be penalized."
Also, "see attached" is not ever a acceptable form of information, and we'll see tax returns where if you look at the front page of a 1040, let's say, and you have more than four dependents, it'll say "see attached," and they'll list all the dependents in the statement. We can't use "see attached" on the K-2/K-3, so if you have more information than that page allows, you add a second of that same page to continue adding the information. There's no white papers included with the K-2/K-3. Also, everything on the K-two, K-three is going to be in USD except for specific areas where the IRS has specifically put it in the functional currency, so keep that in mind. We're talking about USD.
And then, we jump into the form. The front of the first page of the form is the basic information like you would see on any form, and so you would enter the regular identifying information, and you check all the boxes of the different sections that would be relevant. Someone just asked, "Would there be a penalty for completing sections that the IRS deems not relevant?" I thought about that as well. I don't know the answer. Like I said, I've seen people being overly cautious versus underly cautious, but could they come back and say the K-3 wasn't completed properly because it's not relevant? Yeah, they could. "You shouldn't have had it." I assume they can. I doubt, because the goal of this was transparency and more information versus less information, that that's the taxpayer that the IRS is going to go after, but I don't know. Your guess is as good as mine, and it's a very good and relevant question for while we're thinking about which sections of the K-2 we should complete. Oh, we have our first polling question. I'll just hand it over to Astrid.
Astrid Garcia: Polling Question #2.
Ayelet Duskis: The specific reason why I asked this question was because I wanted to see before we jump into the K-2/K-3 how well you have touched these forms, how much you know about it, how much you've seen. Not that people that received the forms aren't also learning about the forms, but there is something unique about being the person that prepares the forms that helps you really learn and know them. So, of course, I asked the question just to kind of get a taste of your experience before we dive in.
Astrid Garcia: Great. I'll be closing the polling question now. Please make sure you submitted your answer. Back to you.
Ayelet Duskis: All right, so it looks like we're dealing with the middle ground over there. We've got people that have prepared under 10, or a bunch that have prepared between 10 and 50, some between 50 and 100, and not many that are over 100. I can safely say that I've prepared well over 100 K-2s, so unfortunately, I can almost do this in my sleep, which is why I'm happy to share this with you guys today. So, we're going to start jumping in.
First of all, when can I not, as a partnership, prepare the Schedule K-2/K-3? There is an exception to filing the K-2/K-3. It's very, very minimal exception. There has to be no foreign activity or such a limited amount of foreign activity that the income would only be eligible for a $300 foreign tax credit. It's a really backwards way to say it, but if I had X amount of taxes due, my foreign source income should be so little that only 300 of that would be eligible for tax credit. So, when I do the math backwards, that comes back to about $810 if we're looking at a 37% tax rate.
So, I really have to have a minimal, minimal, minimal amount of foreign activity. All of my partners have to be U.S. citizens, resident aliens. They cannot be foreign in any way, shape, or form. And also, all of my partners have to be individuals, trusts, S-corps with one shareholder, or a single-member LLC. None of my partners can be other partnerships. As soon as I have another partnership, it doesn't matter foreign or U.S., I'm done. As soon as I have a corporate partner, it doesn't matter foreign or U.S. income, I'm done. I must prepare the K-2/K-3. But if I have individuals, trusts, S-corps with only one shareholder, then I can still possibly be on this exemption of filing the K-2/K-3. But if I am going to be in this exemption, then I have to actually provide notification to the partners that it's not going to be provided, and I have to wait a month and make sure that the partners don't come back to me and request it. Because if a partner requests it, we must provide it.
That's part of the exception. One of the ways that I'm seeing partnerships overcome that if they are eligible for the exception is including a footnote that says, "We are not going to provide the schedule K-3." Provide the K-1s to the partners, and then wait a month and not actually file the tax return until a month passes and none of the partners came back and said, "Wait, can we have the K-2/K-3?" That's kind of another thing. If the partnership was sending an email out to all their partners in the beginning of the year, they could send a written notification in their email, "By the way, we're not providing the K-2/K-3," but you have to provide those, sort of. You have to provide that, and you have to get that 30 days that nobody requests it.
All right. This is the first page of the K-2 form. I'm just going to note that I am using the 2022 forms. The 2023 forms have just been released. They're not any different than the 2022 forms, besides for one thing on this very first page, which I'll show you in a minute. Therefore, I just left it with the 2022 forms inside the PowerPoint. But again, if you put the two forms next to each other, you're not going to see so many differences. As we discussed, the top half is going to have all your regular partnership information, and then you're going to check every box that applies for which sections of the K-2/K-3 you're going to ride to your partners, and then there's Part I.
Now, Part I is my greatest anomaly of the K-2/K-3, because like I said, the IRS said that they're trying to have transparency, they're trying to have everything be in a formal way all the same, and then they have this whole section where it's all this other information that we're not including on the K-2/K-3. Check the box if you have it, and if you have it, you have to provide that information separately to the partners. So, it kind of feels like this big anomaly to me. Doesn't seem to fit in with the lines of what the K-2/K-3 are all about. Again, I don't know if the IRS is 100%. It could be that they have areas that say, "Reserved for future use." It could be that they're going to add more things, but I don't know.
So, when I look at that first section, first of all, box number seven, where it says Form 8858 information, that's the one thing that changed on the 2023 form. Now, you don't have to check that box if you have an 8858 that you're filing, and instead, it just says "Reserved for future use." So, there's nothing there right now. Some really important boxes to keep in mind is box four, foreign tax translation. Anytime that the partnership paid foreign taxes, they have to check that box, and they have to include on the statement with their K-3 that shows the taxes in the functional currency the exchange rate and the taxes in USD. So again, that's a statement, even though the IRS is trying not to have statements, that's number one.
Number two is box five. That says high-taxed income. So, you might be like, "Oh, I only have to check the box if my income..." No. Anytime that the partnership has passive income, it's possible that for the partner when they're filing their Form 1116, it's going to be considered high-taxed income and it's going to get a high tax kick out. So, anytime you have passive income, you've got to check that box, and there is a... I'm just going to flip for one second. I'll flip back. It's not here. There's a worksheet that you're going to include, and in that worksheet, you're going to put the amount of the passive income and the different withholding rates so that the taxpayer, when they receive the K-3, can determine if this passive income is subject to the high tax kick out. So, any time you have passive income, even if you didn't pay taxes on it, you need to stick that box.
Another box that's important is box eight, Form 5471 information. You have to check that box if you have U.S. shareholders that need the 5471. So, if you have U.S. shareholders of your partnership, and obviously, you file the Form 5471, you're going to check that box, and you're going to include the 5471 with their return. You don't have to include the 5471 for everybody, just the U.S. shareholders, and you don't have to include a 5471 any time you filed it. You have to include the 5471 for the U.S. shareholders that might need it.
Box nine, which says other forms, you don't actually have to include the other forms, but that includes if you file an 8621, you check that box. If you file the treaty position, you check that box. So again, you're just checking, letting them know. And then of course, my very, very favorite box of all is box 13, because box 13 is other, and the main other that we have over there is 926. So, there's nowhere on the K-2/K-3 to put 926 information. So, when a partnership directly or indirectly gives money to a foreign corporation, they have to give that information over to the partner to determine if they have to file a Form 926. We've always given it over as footnotes, and we still are going to give it over as footnotes, but we're going to check that box and then attach the footnote.
On that same note, if the partnership is a foreign partnership and the partner possibly has an 8865 filing requirement, we're also going to check box 13. We're not going to include any of the information that the partner needs to file the Form 8865 on the K-2/K-3, but we're going to do what we've continually done up until now and have a statement included with the K-two that gives the partner all the information that they need to file the 8865.
So again, I find that to be the biggest anomaly that there can be. Hello? I thought you want formality. I thought you want everything to look the same. I thought no more white paper. Box 13 completely throws it out the window, and box 13 is something that you see checked a lot, especially in my space, in the financial services space. If you have venture capital funds putting money in startups, you're going to be checking that box. If you're a foreign partnership and you have U.S. partners, you're going to be checking that box. I just find it very interesting. These are my little thoughts of these forms. This is how the K-3 looks for the partner versus the partnership. So again, it's the identifying information of the partnership, identifying information of the partner, and checking the boxes for which sections apply.
And then, without further ado, we get to the meat and potatoes of the form. The first two sections of the K-2/K-3, Part II and Part III are really what replace the Line 16 from the old K-1s. This is everything that the partners need in order to prepare their own Form 1116 or 1118, whatever, if they're... It's much, much, much more detailed than what the old Line 16 was. There's a lot of different pieces of information. First of all, we're breaking out all of the different types of income, and we've got Part I. Section 1 of Part II is the gross income, and then Section 2 is the deductions, so we're breaking out income and deductions. We're not providing a net number. We're breaking out different types of income. We're not providing a net number. We're going to show if it's passive income, if it's general limitation.
E, our favorite, is the other box, which is the 901(j) income. So, if you're doing business with Iran, that foreign source income would go in box E. Interestingly, also, we have to break it out by country. So, even though we know that on the 1116, everything gets munched together, which there are some foreign tax credit legislation out there that could possibly change that, but for right now, everything gets bunched together into one country. We have to break it out by country. We can't write "other country." You can't write "various." You have to write the name of the country and show the income. That means also that if you have income coming from Israel and you have income coming from Canada, you can't just say Israel and bunch it all in one. You got to break out Israel. You got to break out Canada.
One of the big questions that people have is, "What happens for my income that's sourced by partner." The IRS does let us put sourced by partner. The IRS does let us put the... just simply for that in XX, meaning at first, people, because you couldn't put anything, were putting U.S. That's not really true, because it's sourced by partner. So, specifically for capital gains or other things like that, you can put an XX, but you cannot put "various." You cannot put "other countries." Another question that a lot of people have asked is, "What happens when you get a million K-1s, and there's a list of 15 different countries, and each one has $2 sourced to that country? Do I really have to break it out by all of those countries?" The answer is yes. Logically, is that what you're doing? I don't know. I have been in situations where I have told my tax preparers, "Look at the top five. If you've got 15, look at the top five that they have a thousand dollars each and stick the rest into the top five if they're each $5 and $3 and $2."
It's possible the IRS could come back to me and say, "Sorry, that's not substantially complete." I hope they're not going to say that, but we also have to try to be logical in this, because it would be insane if you have a big fund of funds and you're receiving many, many K-1s to then sit there and list out every single country. If it could be 15 countries. Obviously, if it's one or two or three countries, it's not so bad. But that's just to keep in mind, is that really the IRS wants us completely listing out country by country.
Interestingly enough, when is it relevant to complete this form? So, relevance, again, is not based on what I think is relevant. It's based on when the IRS thinks it's relevant. So, I would think it's relevant to complete this form when I have foreign sourced income, but the IRS says, "No, no, no, it's relevant to complete this form anytime you have a partner that's eligible to take a foreign tax credit." So, i.e., anytime you have a U.S. partner, because any U.S. partner, whether they're a corporation or an individual or they're a partnership who then indirectly has corporations and individuals and trusts as their partners, any of those U.S. partners are eligible to take a foreign tax credit.
So, I don't really care if you have only U.S. sourced income. You must fill out Part II and Part III as long as you have a U.S. partner. Once you have to file the K-2/K-3, unless you're a partnership that has no U.S. partners, which sometimes happens, but rarely, you're going to see the Part II and Part III on every single K-2 or K-3 that you receive, and pretty much every single K-2 or K-3 that you're going to prepare.
There is another exception, not exception to filing, but another just to make life maybe a little easier. If all the partners are less than 10% owners in the company, then you can stick all the income, even the general sourced income into the passive basket. So, really, if you're like a fund of funds, again, we're going to go back to that one, and you get a bunch of K-1s, and some of those K-1s have income that's like general limitation income, because it's line one business income, you wouldn't necessarily have to stick it in that general basket. If all of your partners are just investors, and they own 1% or 2%, you can stick everything into the passive basket, so at least that maybe would make things a little bit easier.
This is the deductions. You can see, again, it's the same categories. These are the categories that we're used to from the 1116s, so anybody that has experience preparing an 1116, which I know all of my Israeli friends definitely do, we've got a regular, our passive, our general, our foreign branch income. A partnership is not going to have foreign branch income, because a partnership can't have a foreign branch. A partnership can't have a foreign branch. You would look at it as if the partners owned directly. If they would consider that foreign branch income, you would stick it in there.
Somebody asked a really good question right now. If they were to lump a few countries together because they had the list of 15, then would you put the XX instead of the name of the country? And the answer is no. No. The IRS doesn't want to see "various," they don't want to see "other countries." The XX is only for sourced by partner. Otherwise, you want to make sure that you've put the names of the countries, even if you're going to do some shtick because of the lists are too long. You definitely need to have a name of a country listed over there.
Also very interesting is that there's nowhere to put the GILTI income, right? So what happens if the partnership is a U.S. shareholder or the partnership has a CFC? We know that if the partnership has a CFC that nowadays, post-Tax Cuts and Jobs Act, the income from the GILTI income or the Subpart F income does not flow through the partnership. It goes directly only to the partners that are U.S. shareholders, and then they would pick up that income on their tax return. Therefore, Part II is not going to have a bucket for the 951A income. Even though on our 1116, we have the 951 A category income, we're not going to see it here.
The other one that we don't see is income resourced by treaty. Why? Again, not a hundred percent clear to me, but you would put that in any section that was applicable to. If it was resourced by treaty and then became passive, you would stick it in the passive bucket. But in general, that's following the same rules that we're used to when we're completing the Form 1116. When we're receiving the K-2/K-3 and we're completing a Form 1116, and we're able to then look and hopefully pretty clearly and accurately compute the foreign tax credit for our clients. With that, I'm going to take you to the polling question.
Astrid Garcia: Polling Question #3.
Ayelet Duskis: I asked this question also with specific thoughts in mind. As a person receiving a K-1, I definitely think the K-2/K-3 is so much better than the Line 16. It's much harder as a preparer than the Line 16, but I even in some ways find it better, too, because the Line 16, we used to have to lump things together to try to put them in their different buckets, and it was a little complicated. I actually think this is more clear. It's a lot more work, but I actually think it's more clear. Oh, that's funny. It's not really a yes or no question. Say yes if you missed the old Line 16 and say no if you don't. Put it that way.
Astrid Garcia: Perfect. I will be closing the polling question now. Please make sure you submitted your answer.
Ayelet Duskis: Great. Many of you do miss the old Line 16. I'm not sure, because that got messed up. Like I said, I don't miss the old Line 16. Somebody asked if I could repeat where the GILTI goes. So, as a reminder, any GILTI income, the partnership doesn't pick up the GILTI income. Only the U.S. shareholder partners would pick it up, so it's outside of the partnership, therefore the income is not on the K-2/K-3. I'm going to show you where the taxes go, because there are still taxes paid associated with that, so I'm going to show you where that goes. But there is no spot for 951A income, because the partnership itself wouldn't have 951A income.
With that note, everyone that's been to my trainings before knows I like cheat sheets. I can't talk about sourcing without providing you guys with my sourcing cheat sheet. This is my, where do I source the income? This has nothing to do with the treaty. So whether you're in Israel or any other country, could be things would be different if you're using a treaty. But this is the basic rules for how to source income regardless of treaty. Interest is based on the residence of the payor, the person paying the interest. Dividends is if it's a U.S. or foreign corp. Rent's easy, location of the property. Royalties is also the location of where the property was used. The sale of real property is where the property was located. The sale of personal property is sourced by partner, the seller's tax home.
Service income is where the services were performed. Inventory, it's where it's sold. Pension distributions, again, this is irrespective of the treaty, so if you're in Israel, it might be different, is where the services were performed that earned the pension. Expenses directly allocable to the income, meaning like if I have gross income and then cost of goods sold, so that's directly allocable to the income, those expenses are going to be sourced based on where the income was sourced. Other expenses are based on seller's tax home or sourced by partner. Interest expense is also generally based on the seller's tax home, sourced by partner, unless you have corporate partners, which we're going to talk about in two seconds. So this is, again, this is Ayelet's cheat sheet. It's just something for you guys to use to help, and gives you all the copy of the slides, but to help when you're preparing the forms, just to figure out where things go or where they should be sourced.
So we get to Part III. Part II was all that information that the basic information that you need to complete the 1116, but Part III is all that extra information that you may or may not need. So, Section 1 is only if you have research and experiment costs. In research and experiment expenses, it's sourced based on where the gross income would be sourced. It's like directly allocable. You only need to complete this if you have the R&E expenses. If you don't have the R&E expenses, you can leave this blank. The same with Section 2.
Section 2 is interest expense apportionment factors. In general, we said interest expense is sourced based on the home of the taxpayer, sourced by partner, except for corporations. Corporations, you're supposed to look at the assets of the corporation and figure out based on the location of the assets where the interest should be sourced. So, in this situation, if you have corporate partners that have over 10% in your partnership, then you need to complete Section 2. Again, this is only if you have corporate partners. They have more than 10% in the partnership, you need to complete Section 2. That being said, if you're just a regular U.S. person and you get the K and you get...
If you're just a regular US person and you get your K-3 and section 2 is completed, and you're an individual, that doesn't mean that now you need to take this information and try to figure out how your interest is sourced. It just means that they filled it out for you because they were filling it out for other partners. It's not reflective of what you need to include on your tax return itself, and that, we're going to see that as a theme over and over again in the forms. So it's really important when you go through the forms, you keep in mind who your client, who is that you're preparing the tax returns for, and if that information is actually something that's relevant for me, or if the IRS kind of forced the partnership to complete it, even if it's not actually relevant. So we go, oh, we have our next polling question.
Astrid Garcia: Polling Question #4.
Ayelet Duskis: Okay, so while you guys are answering that question, I have a few questions, a lot of questions over here, so I'm going to answer a couple of them before we move on to the next section. Somebody asked if we're sourcing, how are you sourcing sales? And I said sales are like where you are. How are you sourcing sales if the goods are shipped outside the US, but the seller's in the US and the warehouse is in the US? So if the seller in the warehouse are in the US, I would source it to the US. That's my answer. Maybe you'd find someone that would say differently, but that's my answer.
Somebody else asked how the partnership would tell the taxpayer that they're guilty if it's not on the K-1? It's a great question. We're going to get to it. It's another one of the parts of the K-2, K-3 that gives over the information to the partner. So you will see that soon. Let's see. Also, a lot of people were asking questions about providing the notification that the K-2, K-3 won't be prepared. I do actually believe that it is supposed to be provided by, I think it's the original due date of the tax return, that statement that it's not going to be prepared.
I haven't necessarily seen that happen in practice, but I definitely think that that's the actual requirement, which is why I have clients that send out letters every year to all of their partners in the beginning of the year, like, "These are the states we're expecting to file and these are blah, blah, blah, blah, blah." They might want to add a line over there at that point in the beginning of the year. Again, what I've seen more is that it's just included as a footnote of the K-1, even if it's past the 3/15 deadline and then they wait the 30 days before they file the tax return. And then somebody else asks if one partner requests a K 3, do they have to provide the K for all the partners? And the answer, I believe, is yes, because once one partner requests it, you're not eligible for the exemption anymore. So it's kind of a sucky situation to be in.
Astrid Garcia: Right, I'll be closing the polling question now. Please make sure you submit your answer. Back to you.
Ayelet Duskis: Awesome. So which of the following is not sourced based on the residence of the taxpayers or capital gains on the sale of stock? That's residence of a taxpayer distribution is an excess of basis from an investment partnership with no ECI, that's treated the same as a regular capital gain. So that's going to be sourced based on where the taxpayer is. Capital gains from the sale of real property. So I sell a house or I sell a building, that's going to be sourced to wherever the building was. So that's the right answer. That's the one that's not sourced based on the residence of the taxpayer.
One more thing before I continue, one more question. Somebody asked if I could clarify when I'm talking about partners and partnerships. So I'm not just talking about partnerships with foreign partners, I'm talking about any partnership. So the K-2, K-3 is applicable to every single partnership that is filing a US tax return, whether they're a US partnership or a foreign partnership. It's applicable to them, and it's applicable to US partners and foreign partners, different sections applicable to different ones of them, but just know that we're talking about everyone. We're talking about the big picture here. So that's really important that we keep in mind. Part II and part III, which we're talking about right now, is specifically if you have US partners, you could be a foreign partnership with US partners, you could be a US partnership with US partners, if you have those US partners, you're completing part II and part III.
The next section of part III, as we were going through it is the FDII, which you can see down here is the section III. This, again, this is for corporate partners who are eligible to receive the FDII deduction. We're giving them their apportionment factors. You don't have to complete this if you don't have foreign partners. When you do complete it, the apportionment is based on the source of the gross receipts. It's important to keep in mind. Oh, next one, Astrid.
Astrid Garcia: Polling Question #5.
Ayelet Duskis: So yes, we have been sitting through this class for now 40 minutes listening to me talk about K-2, K-3. So are you still awake? Yes or no? I'm a little silly, and I answered all of the questions. I should have realized this home was coming, and waited to answer all of the questions until it came, but I don't really see more.
Astrid Garcia: Great, we will be closing the polling question now. Please make sure you submit your answer. Back to you.
Ayelet Duskis: All right. I'm glad 88% of you are awake. For those of you that are taking a nap, I'm grateful to be able to provide you with such a nice nap. Awesome. All right. On that note, we get to our favorite section of part three, because this is extremely relevant to everything else. You can't have a foreign tax credit, it doesn't matter how much the foreign sourcing is, if you don't have foreign taxes paid. So section four of the foreign tax of the part three is where you actually put the foreign taxes paid. Remember again, you're putting this in USD, not in the functional currency, but you need to provide a footnote. This is where, remember we checked that box, I think it's box four on the first page that said "foreign tax translation". And so it's that same footnote that we're going to provide that says the date that taxes were paid and accrued, the exchange rate that was used, and the amounts in both USD and functional currency.
But what you're seeing on this section on the actual form is where the taxes paid are accrued. We're going to break it up by country, and again, we're going to break it out by section of what? By type of what we're used to seeing by category by bucket that we're used to seeing on the 1116, we have our 951 A bucket, we have our foreign branch bucket, our passive, and our general bucket, and then of course our other, which is when we do business with Iran. But we are also going to tell them the type of tax. So sometimes it's withholding tax, sometimes it's taxes paid on ECI, sometimes it's other. So there's a bunch of different codes, and I put in the little corner of the page the cutout from the instructions to the form of what all the different codes are. So should you need to know what the code represents, you can look here, you can look in the instructions of the form, but those are going to tell them what type of taxes it was.
So if it was a dividend, it's withholding tax on the dividend by whatever country the dividend was paid from, or etc., etc. And again, it's straightforward in the sense that it's the same buckets that we're used to on the 1116. We're breaking down here. We do see the 951 cap A, because even though the partnership doesn't pick up the guilty tax, if they pay taxes on the guilty income, they would still provide that information to the partners, that the partners could still be eligible to use that as a foreign tax credit. Okay, and the last part of part three is section five, and this is the 743B information. So you obviously you only fill this out if you have 743B adjustments, and this would just again help with the sourcing 743Bs, when we have steps up in basis, then we're making specific adjustments.
So somebody asked, "What if the withholding is not final?" It's a good question. I guess that is why we're going to say you check the box accrued, not paid, and you might have to make an adjustment in the following year. I've definitely had times where we've had to make adjustments. In year one we said it was a 100 and it only ended up being 50, and in year two it was 50, we might choose zero. So again, we have a filing deadline, so we'll do the best we can, but we still have to reach our filing deadline.
Okay, so a good question also is, "What do you fill out in part three if there isn't anything foreign, like the K-2 is only being filled out because you have foreign partners?" If you only have foreign partners, you're not filling out parts two and part three. Parts two and part three are only if you have US partners. If none of these boxes are applicable, if we go back to all of the different sections, if there's no 743B adjustment and there's no corporate partners and interest expense, there's no research costs, or there's no foreign taxes paid, this part three could still be blank. But remember that if you have foreign partners, if the whole partnership is consisting of foreign partners, you haven't filled out the section, anyways.
Okay, then we move on to part four. So again, I'm going through it section by section with you and I'm going to explain sort of to the people how it's prepared and also how it's read. So part four is again specifically for corporate partners, but it is also for people that are eligible to making a 962 election, i.e. individual partners. So we have the FDII, the form derived intangible income. It's a certain deduction that corporations are able to take. It's on the form 8993. And here is where we're providing them, it's a mathematical calculation, the FDII, and here's really where we're just providing them all that information so that they're able to calculate the FDII. We only have to fill it out if we have the corporate partners, or again, if we have US partners eligible to make the 962 election, we are technically supposed to complete this as well.
Let's see. I think that's about everything. So it's every partnership with a direct or indirect corporate partner. So again, if you have partnerships that are partners, this is one of those places where you don't know if they have corporate partners. So you're going to have to fill out this section, which basically means any time you have a partnership that has corporate individual, because then remember they're able to make the 962 election or partnerships as partners, part four is going to be filled out. So in general, part four is probably always going to be completed. If you're an investment partnership, it's not going to necessarily be completed, because you might not really have gross receipts, cost of it sold, etc. But this is again a section that you're going to see a lot.
Now, as the person receiving the K-2 or the K-3, I might not need this information, because I know I'm not making a 962 election. I know I'm not a corporation. The partnership maybe filled it out because they had all these other people that were, they had partnerships as partners and they had other people that were eligible for. I received it, I didn't necessarily need it, but I received it. Therefore, it's on the form, but it doesn't mean I need to do anything with it. So again, there's something that when we're going through the form, we have to keep in mind, not everything on the form do I need as a tax preparer for my client's tax return. And this is one of those sections that I very much might not... They might say, "Well, I could make a 962 election," so I'm going to provide that information, but I know I'm not, so I don't need it. They don't know I'm not, so they gave it to me. So it's important to keep in mind. Right, I think we're actually at our next polling question, Astrid.
Astrid Garcia: Polling Question #6.
Ayelet Duskis: Right, so again, one of the reasons why I asked this question is because it's not 100% clear, and I have seen, again, we have people that are concerned that the IRS is going to come to them on part five and say, "This wasn't substantially complete, so why don't we give you a penalty?" So they'll include all foreign corporations, even though the instructions say just four CFCs, I'm going to show you the form in the second, but I wanted to know if anybody else besides myself had opinions on it, because I see a lot of partnerships including all distributions from corporations, regardless of if they're CFCs or not. Oh, we still have people answering.
Astrid Garcia: Yeah, I still have a couple more answering. Please make sure you've submitted your polling question to make sure you get credit. Give it a few more seconds. And I will be closing the poll now. Back to you.
Ayelet Duskis: All right, perfect. So a lot of people are saying to include just all foreign corporations. This is the part five, this is what it looks like. You have the name, you have the EIN, the date of the distribution. This is where we're going to put the functional currency, the amount that you're using, and the actual amount in the functional currency. And then you're going to put the amount of it that was applicable to earnings and profits, because you could have had $100 of distributions but only $50 of earnings, so only $50 of that would be considered a dividend. We're going to show the spot rate where you translated it to USD, the amount in USD, and then the amount in USD that's applicable for EMP, the amount that's actually distribution.
So what's the point of part five? And again, I've seen more than one person include it for any distributions possible. But the instructions of the forum say you only have to complete part five if you know that you have US shareholders that are partners of CFCs that you guys own, or if you'll have partnerships that are eligible to take the 245A deductions. So that's again, it's like a dividend received deduction. So not necessarily going to see this completed, but again, what's the point when we're talking about guilty specifically? So guilty, again, we said the partnership is not going to pick up guilty income.
The partnership, if they have guilty income, is going to give that information over to the partners that are US shareholders and they are going to pick up the guilty income outside of the partnership. But what happens, we know that when a person picks up guilty income, that goes into the previously tax earnings and profits bucket, and when that same person, that same shareholder takes out a distribution, they're not going to be taxed on that distribution to the extent that it was already included in the previously taxed earnings and profits.
So if I had $100 of guilty income and then in year two I had $110 of distribution, 100 of it would be applicable to last year's PTP. And my distribution, that dividend that I'd pick up would only be $10. So what does my partnership do? My partnership gets a distribution. My partnership didn't pick up guilty income. They don't have any previously taxed earnings and profits. As long as that distribution is coming from earnings and profits, they're going to pick it up as a dividend. So I'm going to receive my K-1 and it's going to say, "Hey, I got a dividend of 50 bucks," or whatever we said, remember we did the same example. "I got my dividend of $110. Excellent, I have my dividend of $110," except, and this is what's really important to keep in mind, if I'm a US shareholder, the taxpayer that receives it is a US shareholder, and they know that they're going to pick up guilty income.
They know that they really should only be picking up a dividend of $10, because last year they picked up guilty income of $100. So that's the information that we're giving over here, that now the US shareholder partner, who remember, we also are going to provide them the rest of the guilty information that they need, the next section. And remember, we also provided them a copy of the 5471, so hopefully they have all of the information they need, but they also need to know how much of those dividends on page one of the K-1 that I received from you are really dividends from what's for me previously taxed earnings and profits, even if for the partnership, it's not previously taxed earnings and profits. So that is what we're seeing over here. Now, included in part five is a worksheet, because again, they're trying to do formality, but then they have worksheets included also.
The worksheet is specifically, and I'll flip to the page, the worksheet is specifically regarding NII PTEP. So again, sometimes we have net investment income tax, the Obamacare tax, when the distribution comes out, they pay the Obamacare tax, or you can make an election to pay the Obamacare when you pick up the guilty, but the partner decides on the information of what they're picking up as income on their tax return. It's what they're paying the NII on. So those worksheets are giving over the information about what they're paying the NII on. Now again, what I've seen is in some foreign partnerships, including all the distributions that they've received. Now, another spot, and this doesn't say on the instructions to the forum, where that would be applicable, is if I'm a foreign partnership and I'm not allowed to make QEF election, we're going to talk about PFICs soon.
Anybody who knows me knows PFICs are my favorite topic. We're going to talk about PFICs soon, but again, I'm not eligible, as the foreign partnership, to make the QEF election, but my partners might make the QEF election. So again, when I get a dividend, if I've made a QEF election, then my dividend would've been reduced by the income I've already picked up as QEF income. But the partnership can't make a QEF election, because they're a foreign partnership. So again, for them, they're going to pick up a dividend, and I'm going to need to know how much of that is applicable to the QEF income that I've already picked up.
So what I do, personally, on any of the foreign partnerships that I pick up where I'm also providing QEF information to the partners, is I do complete part five, even if that's not actually what it says in the instruction of the forum, because I think that's what makes sense. And again, that's kind of why I asked that question, because I've seen it go both ways, and I've seen people who I view as the most knowledgeable in US four international tax issues completing part five. So it could go either way, but really, the idea is, the concept is that when something is happening outside of the partnership that could affect the dividend reporting specifically for that partner. And that is part five.
And then we finally have part six, which is where you actually have the guilty information. So the IRS tells us that you have some exceptions for this. You only have to complete part six if you know that you have a US shareholder, direct or indirect US shareholder. If you know that there's no way possible, like again, the partnership has a CFC, but you know that there's no way possible for any of the partners to have, directly or indirectly US shareholders, let's say they have a hundred partners and each partner has 1%, so even if one of the partners is a partnership, there's no way that any of their partners could own 10% in this CFC either, then you don't have to complete part six.
You also don't have to complete part six if the entity is a CFC just because of downward attribution. So we're talking about, here, direct CFC, not foreign controlled CFCs, regular CFCs, that the partner might have to pick up some part of our guilty income, whereas we know the partnership did not complete, pick up that income. So we're going to provide them basically everything that they need to make that calculation over here. So we've got the name of the CFC, we have the EIN the tax year, the amount of sub-part F income, the amount of tested income, the amount of tested loss, basically everything that you would expect to see in order for the partner to calculate their income inclusion amounts. It's straightforward. Maybe figuring out what the numbers are isn't straightforward, but reading the form itself is fairly straightforward.
You also can see in box A that it says way, way on the top, "Separate category." So we still have those separate categories just like we have on the 5471s, where you're going to put if it's 951A income, or if it's passive income. So you might have two of part sixes, one for the guilty income and one for the sub-part F income. That's all going to be included on this form, though. And again, with the IRS on these forms, you never say, "See attached," to add more information. So you wouldn't necessarily find it strange to see two part sixes.
Just like you could see three pages of part two, section one, because you can have a bunch of different countries. So our K-2, our K-3s we're providing to our partners can end up being 60, 70 pages long if we keep having more and more of these, and then we attach the 5471. So we're giving them huge packages at the end, but we're going to keep adding to it. It's not unusual to see two part sixes, or two part twos, or two part sevens, which is the next part. So polling question number seven.
Astrid Garcia: Polling Question #7.
Right, 130 minutes. I think I need to move a little bit slower. It's a ton of information here. So let's see if I can answer some questions, also, before we get on. Big thanks for talking about PFICs in the questions. I'm trying to see if there's any questions here. Somebody asked if I could show an example on the forms about how the 110 dividends, it's only 10, is tax will be reported on the schedule. Astrid, am I able to go back, even though it's after the polling question, to those forms for a minute?
Astrid Garcia: Let me first close the polling question, because once we get out of this slide, it'll close it. So give it a few more seconds, just for people to finish, submit it there, their answers, and then you'll be able to go back. Okay, I'll close the polling question now, and you can go back if you need to.
Ayelet Duskis: All right, you guys are excited to hear me talking about PFICs. That's what it sounds like. Okay, so before we talk about PFICs, I'm going to go back for one second, because we do have time, and I want to make sure that you understand. So if we look here at part five, we're going to just put the actual distribution information. We're not going to tell them that only $10 is taxable of the 110. We're going to go back to that example. So let's pretend our functional currency is USD. So we're going to tell them that the functional currency, that the amount of the distribution and functional currency was 110. We're going to tell them that the amount of the EMP, let's say we had a 100 last year and we had another 10 this year. So we're going to tell them that all of it was applicable to EMP. Because it's in USD, our spot rate's going to be one, and we're going to show them the same numbers again.
So that's all we're going to do over here. The partner, then, again, so we've got our box. We've filled out our box H with 110 or box I with 110. So they know everything is applicable to EMP, which means that on their K-1, on the front page of their K-1, they are going to see a dividend of 110. So they know now that they've got a dividend of 110 and it's all applicable to XYZ Partnership, Corporation where they know they're a US shareholder. Then we go to part six, and we're going to put XYZ Corporation, and we're going to put over here on the top of section A951A income. And then we're just, we're literally going to write, let's say we have tested income of 110, so we're going to put... Or 100, so we're going to put tested income of 100.
So now they know, so it's going to take some knowledge on their part. It's not necessarily so clear and straightforward, because again, the partnership can't tell them the amounts that they've picked up. The partnership doesn't know what they've done after they got their K-1. I mean, maybe they do because they're related, but think about if they're two separate individuals. The partnership prepared the K-1, the partnership gave all the information to the US shareholder. The US shareholder did whatever the US shareholder was supposed to do with it. The partnership has no idea what the US shareholder actually did. If they picked up sub-part F income, if they picked up guilty income, they don't know. So all they can say is, "Listen, you got $110 from XYZ Corporation, you also had tested income of $100.
So now, there has to be some level of sophistication on the person then preparing the tax return, who then has to be able to know, "Okay, well if I'm picking up $100 of guilty income, I'm not also going to pick up $110 of dividends, because I know that that's the same income." Again, so that person that's preparing it kind of has to be used to and aware of what the schedule J, which is my favorite schedule on the 5471, has to look like before they would complete this, before they would, that information would be clear. So I was kind of explaining to you the back story, but we have to keep in mind that the partnership really doesn't know what the partner did. They can't tell the partner. They can only tell the partner, "This is the amount of the dividends from XYZ Corp, and this is the amount of your tested income from XYZ Corp." You have to know what to do with that, because I can't tell you.
And that probably, honestly, is where I get the most questions during tax season because somebody, whether they're from EisnerAmper, or they're just one of my dear friends from the Israeli-US CPA community, gets all this information, and it's really complicated, and it's really hard to figure out, "What am I going to do and how am I going to figure that out?" But we're going to keep in mind, always remember that you're only going to be taxed, as much as I like joking around or saying, "The IRS isn't reasonable, even though they're telling us to be reasonable," you're only going to be taxed one time on those earnings and profits. It would not be correct to have to pay $100 of guilty income and then $100 of distributions on the same income. So we have to keep that in mind.
We know the concepts of PTEP, and of 5471s, and CFCs, and then we have to sort of do that math. It's not going to come straightforward to us on a platter. It's going to take a level of knowledge, which also leaves a lot of rooms for mistakes, which is one of the... Why I have clients sometimes that come to me, they've just moved to Israel, or potential clients, and they really just want to stay with their accountant that was from the US. And I ask them like, "How many times does their accountant deal with people that live outside of the US, and maybe have more relevance with CFCs and other things like that?" And a lot of times, that's where you see mistakes, because the stuff really is really hard. It's not easy. So I do this day in and day out, all the time, every day so much, and that's why I know it, but it's really complicated.
And again, so even just this, you have to know what you're seeing in part five. You have to know what you're seeing in part six. You have to know what then you're doing on your tax return and put... And what you've received on the front page of your K-1, and then put all of those pieces together in order to figure it out. Takes a little bit of mind games over there, and it's why I think taxes are fun, but you're all sitting there going, "Ayelet is a nerd, we love her." We know. All right, so now we'll move on to my absolute favorite topic, PFICs. If we didn't think I was a nerd already, now you do.
Okay, all right. This is another example of where what I think is relevant and what the IRS thinks are relevant are not necessarily the same thing. First of all, who has to fill out part seven? Any single US or foreign partnership that holds PFICs has to fill out part seven, unless they know that there's no direct or indirect partners that are US persons. So let's say all of my partners are foreign individuals. I know that there's no way that this is going to flow through to a US person, because once I have a partnership, it could flow through, then they don't have to complete this section. Or, the partnership is a US partnership, and they've made a valid pedigree QEF or mark-to-market election. What does a "pedigree" mean? It means there was no purge and then it was a QEF, and once it didn't have a good election in place, and now it does. A pedigree QEF or mark-to-market election means that it's the top.
It's like when you get the pedigree dogs and they're the best. It's the QEF that you made on day one, the elections. There's no questions about the elections, nothing like that. Those, when I've made my valid QEF, pedigree QEF or mark-to-market elections, I do not have to complete part seven, if that's the only PFICs I have. If I have another PFIC that wasn't eligible for an election, and I'm a US partnership, even though I filed, remember the US partnership is the one that files 8621, it picks up the income, but if it's 1291, and it was subject to 1291, I need to include it on the part seven. even though I filed 8621. So that's one spot where again like, "Hmm, why is the IRS doing that?" You're going to see more of that in this section.
Now also, keep in mind that there are PFIC regulations floating about that that all of us are holding our breath about, which would start to treat PFICs the same way that the sub-party F and the guilty income is treated, where like in foreign partnerships, where the elections would be made by the US partners versus by the US partnership. So it's possible that this is going to change a little, so we're all keeping our eyes out. You don't have to worry about that right now, because it's not changing this year. But keep in mind that it is something that could, priority next year, tax season, because there are proposed regulations out there that could change how we do things, and that's going to be a big and hard change to get adjusted to.
The beginning of this section is pretty easy to prepare. You got the name of the PFAC, you got the EIN, or the reference ID number. Every year, you want to use the same reference ID number. So if my reference ID number was IEL at one, then in year two, my reference ID number is going to be IEL at two, IEL at one again, and so on and so forth. The address of the PFAC, the PFAC's beginning tax year, ending tax year, that's all of the basics that we've got going on over there. Those are all the things that the partner needs to complete, that first page of the 8621, with the identifying information.
There's some interesting information, though, coming at the end. So if we look at information regarding elections, box J, election by the partnership, so remember the partnership might have made their own election, because they were a US partner, but it wasn't a pedigree QEF or mark-to-market election. So in that box J, they're going to tell you, well, they already made a QEF election. It's not pedigree, but it's a QEF election. If you're receiving that, you're probably not filing an 8621 for that tax return. You're knowing that that PFIC is around and it's not pedigree, but they picked up the income. You're not going to do anything with that information.
If you see a QEF over there and online, you could ignore that information. You're not going to include the 8621 with your tax return. Box L is if it's mark-to-market. So box K is if it's an insurance, which I skip over because I don't think many of us see these insurance corporations. Box L is if the stock is marketable stock, they can make a mark-to-market election. Box M is if it's also a CFC. So keep in mind that CFC trumps PFIC, but only for the US shareholders. So it could be that we talked about XYZ Corporation, which we were including that 951A information for, could be that for the other partners that we didn't give the 951A information for, it's a PFIC. So then, we would check that box, and then we've got box N, and this is as the person receiving the K-3. This is a really important box to keep in mind. We know-
The K-3, this is a really important box to keep in mind. We know that there's that famous rule. Once a PFIC, always a PFIC. That's not 100% true. It's once a PFIC, always a PFIC as long as I don't have a valid QEF election in place. If I've made that pedigreed QEF election on day one, when the entity stops being a PFIC, I don't have to treat it as a PFIC anymore.
In the past, if I was a foreign partnership and I invested in a bunch of PFICs, so I'm like an Israeli venture capital fund, and I've invested in a bunch of PFICs, and I'm providing all that PFIC information over to my partners, I just assumed they were going to make the QEF election. I gave them all the information to make the QEF election, I might've added a footnote if he didn't make the QEF election, told him that he information is available upon request, and I assumed that they made the QEF election. Game over.
When it stopped being a PFIC, I didn't even provide the information anymore, because it's not a PFIC anymore. With a QEF election, it doesn't have to be a PFIC anymore. When that box is not checked, the IRS says nowadays with part 7, "We can never assume that our partner made a QEF election." Maybe they didn't for our partner. When that box is checked, it means it's not a PFIC anymore. If you made a valid QEF election, you don't need to file an ABCs 21 for this entity anymore.
You only have to worry about this if you don't have a valid QEF election. As the person receiving the K-3, when I see that, and I see that that box is not checked, I know that this is not actually a PFIC anymore. If I had a valid QEF election going back to the prior years, I'm done. I don't have to treat it as a PFIC anymore. They're providing the 1291 information for whoever didn't make the QEF election, but I'm smart and I know all about PFICs and I made the QEF election, so I'm done. I don't have to worry about it. Those are very important to keep in mind as the person again, receiving the K-1 or the K-3 in this instance.
Okay, the next part. Somebody asks what's supposed to be filled out in part 7 if the only reason the partnership is filing the K-2 is because they have foreign partners. Remember, you only file the sections that are relevant to you. If you only have foreign partners, and again, no direct or indirect partners are US people, all of your partners are foreign individuals or you know that even though there's a partnership as a partner, you know that all of their partners are foreign partners too, you don't fill out parts of it even if you have to be fixed. It doesn't matter, it's blank.
We're going to get to the parts that are for foreign partners. We didn't get there yet. Part 10, you'll see it's for foreign partners. Part 13 is for foreign partners. There are other parts that are foreign partnerships. You're going to say the K-2 isn't really set up for US partnerships either. You're right, it's because the K-2 is only giving over foreign information, but that doesn't mean US partnerships aren't filling this out because remember, any US partnership that has US partners that are eligible to take a foreign tax credit, which is basically every individual or a corporation or flow through entity that's going to then give that information over to their individuals and corporations, has to fill out part 2 and part 3. Whether it's US sourced income or foreign sourced income, you got to fill out parts 2 and part 3.
Yeah, I see what you're saying, but remember, not every section ... some of it is required even though it's annoying, but not every section is required. You really have to look at the instructions to the form and say, "Is this section required for me?" Again, if you were a foreign partnership and you didn't have any US partners at all anywhere, part 7 is not for me. I can skip over part 7. Okay. Remember what I told you, the IRS said, "Well, no, no, no, you can't assume anymore that they've made the elections. They might not have made the elections." All of a sudden, there's way more reporting on my side as the person preparing a bazillion of these, because before I just told them the name of the PFIC and I told them their QAF information and all that, whatever their page one information and et cetera.
But now besides for filling out, I fill out either the QEF information in section two or the mark to market information. I don't have to fill out both, but I must fill out the 1291 information as well, meaning I'm not going to assume they made a QEF election. Maybe they decided not to make a QEF election. Now I've got to give them all of the information that they could possibly need to calculate their 1291 inclusions too. I got the date the PFIC shares were acquired, the amount of cash distributed during that year, the amount of cash distributed for the past three years, so I could figure out what's an excess distribution, dates that it was disposed of, everything that you could possibly need for the section 1291, I have to always provide that also. It's not enough to just provide the QEF information anymore.
That adds a huge level of burden to the tax preparer who's preparing the K-2, K-3. Again, it adds another level of confusion to the person receiving the K-2, K-3, because I got the K-3. Now I have part 7 and I know that I'm going to make my QEF elections. First of all, I have to figure out which PFICs on this list I actually need to make QEF elections on, because some of them are not PFICs anymore, and I don't need QEF elections on that. Once I do that, and then I've got to look and I see all this 1291 information and I'm like, "Oh my God, what am I doing with this 1291 information?" It's like you're not doing anything. You have a valid QEF election. But again, the IRS has to assume that maybe you didn't make a valid QEF election.
You've got to provide that information, but if the partnership had to provide that information, that doesn't mean you have to do anything about it. Again, that's the theme throughout all of this. The partnership has to provide a wealth of information, way more information than you can possibly need because again, there's no way for you to make a QEF election and be subject to 1291 at the same time, but they've provided that overabundance of information and then I need to figure out which one of them is relevant to me. I've got my QEF election, I'm not worried about 1291. If I made those valid QEF elections every year and that box isn't checked, so I know it's not really a PFIC anymore, I don't need to do anything about it anymore. But you have to have that back knowledge of information and understanding to know what you're going to do with this when you then go and put it on your tax return.
That basically takes me to the end of the part 7. It flips a little, because part 8 brings us back to that CFC discussion versus the PFIC discussion. Why didn't they make this part 7 and the PFIC's part 8? I have no idea, but this is Section 960. Anybody who has played around with CFC's knows that a CFC is eligible to take those indirect foreign tax credits. Those are the tax credits that the underlying CFC, the taxes paid that the underlying CFC made the tax payments for.
This is where I'm going to provide that information to my US shareholders. I only have to complete this section. If I have the CFC, I know that I have US shareholder partners and I know that they're eligible to take this indirect foreign taxes, which is either a domestic corporation or partner eligible to make a 962 elections, so individuals basically. If I have US shareholders that are individuals or corporations and I have indirect foreign tax credits, I'm going to complete part 8. I am not going to complete part 8 even if I have a CFC, but I don't have any US shareholder partners. Keep that in mind.
Again, it's fairly straightforward. Now, this is one place where even though the whole form is done in USD, we're providing the information in functional currency. Again, and it says, "Enter amounts in the functional currency of the foreign corporation unless otherwise noted." In this specific situation, this is in functional currency.
All right, we got our next polling question.
Astrid Garcia: Polling Question #8.
Ayelet Duskis: I'm getting some really interesting comments about PFICs. One person said to me, I don't see how anybody could be excited about PFICs. I do PFICs all day long, all day, and all night with the help of one of my most favorite people on my team who is listening in right now and knows who she is, and we both live and breathe PFICs. At a certain point when you know an information so well, you do tend to enjoy it, but yes, I see why you wouldn't think anybody would be excited about PFICs.
Somebody else said, well, they like PFICs too. To each his own, I guess I would say. I got a good question about if we had forums with numbers on them, it would help. I hear that I guess could be a topic of a later date. Also, if there's something specific that you would want to see numbers on, I think you guys most of you have my email address or you can get my email address fairly easily. You could reach out to me and say, "Could you just show me how section session assess would be completed?" I'd be more than happy to provide that to you. It's definitely something for me to keep in mind on future presentations, but don't have that right this second.
Astrid Garcia: Wonderful. I will be closing the polling question now. Please make sure you submit your answer.
Back to you.
Ayelet Duskis: All right, perfect. I think we are moving right along. We're getting to BEAT. I find this one to be one that I generally skip over in the sense that it's part 9, I believe? How many times you actually see BEAT?
Sorry, somebody just wrote, "Is Harvard easier to get into than this form?" Again, I think the answer is "Yes" and that is why, like I said in the beginning, I found it interesting that we marketed this training to our CPA group in Israel, our US CPA group in Israel, and then I saw that there were so many people that were signed up for the training that don't have anything to do with Israel. They saw it on the EisnerAmper website or they saw it on LinkedIn, but the form is so complicated and so confusing and so difficult that nobody knows what they're doing with it. We're into our third year and it's still so complicated and so difficult.
I'm trying to give you guys clarity here. I hope you're going to walk away with some clarity. Obviously, like I said, I'm more than happy to help out should you need by reaching out to me via email, because as you can see, I'm a tax nerd and I like talking about this stuff. But yeah, it's pretty hard. Sorry, I laughed out loud. I had to share that comment with you.
We can go back to BEAT and I'm not talking about music. BEAT is this base erosion anti-abuse tax, and this was the IRS is trying to prevent US companies from shifting their profits to jurisdictions where the tax rates are lower. It's a really difficult computation that I don't really know so well. I don't see it that much and it's not even applicable unless the taxpayers have at least $500 million or more gross receipts for the last three preceding tax year, so I don't know how much any of us in this call, maybe there's someone here, not me, who sees BEATs on a regular basis, but you can't skip a section on the form.
Part 9 is where you would put all the information that you would need for a corporate partner to calculate BEAT. First of all, you don't have to fill out this information. You don't know which corporate partners are at the $500 million gross receipts or not. You can't say, "Well, we don't have $500 million gross receipts. We don't have to fill out part 9." That's not how it works, but you don't have to fill out part 9 if you don't have corporate partners. As long as you know that there are no corporate partners, you don't have to fill out part 9.
I know one question that we've had and was unclear in the instructions to the form is "What about indirect corporate partners?" If I have a partnership that's a partner and then they're going to have corporate partnerships, do I have to fill out the form then? Do I have to fill out this section then? I don't have the answer. Again, I don't know how relevant BEAT actually is. That being said, there's an exception for small partners and their definition of "small partners", which is why I'm using quotations, is their interest in the partnership is valued at below $25 million. Even if I have corporate partners or possible indirect corporate partners, as long as they're ending tax capital on the last day is less than $25 million, it's not really applicable to me. I'm not going to complete part 9 unless I have ... the partners also have to have less than 10% of the capital and less than 10% of the profits. I'm not going to have to complete this part 9, if I have small numbers.
I'm only going to be a partnership with really big numbers in the beginning, that I have $25 million of tax capital to give off to the partner, so that I would be providing this part 9 information to. Also, if my partners are S corps, those are not considered corps that need the BEAT information. Everything that you're going to see here, it aligns with the form 8991, where the corporate partners would use to calculate their BEAT tax.
With that, I have a polling question, which I just thought was interesting. Astrid?
Astrid Garcia: Polling Question #9.
Ayelet Duskis: All right, I don't have any more questions up right now, so either I'm doing a great job or you guys are so confused.
Astrid Garcia: It's a lot of information.
Ayelet Duskis: I know. Astrid, ask me if I'm going to get to 130 minutes and keep in mind that we need 130 minutes and I was like, "Don't worry, I'll get to 130 minutes." Do you understand now, Astrid?
Astrid Garcia: Absolutely. All right, we have still a couple more people that need to submit their answers. Make sure to hit that submit button. Okay, I will be closing the polling question now.
Back to you.
Ayelet Duskis: All right, most of you have not done or received a K-2, K-3 with BEAT information. Me too. Isn't that interesting? Even though I could say that I've done hundreds of them, I haven't seen BEAT really. Again, that's why I tried to get through it as fast as I could.
Then we get to the next section. This section is extremely relevant because part 10 is the section that when you have foreign partners, you need to provide. If you're asking where is it relevant when you have foreign partners? This is where it's relevant if you have foreign partners. When you have foreign partners, you're going to provide them ... part 10 is going to be similar. In my brain, I view it as very similar to parts 2 and parts 3, whereas parts 2 and part 3, I'm providing all this sourcing information for the partners to figure out what's their foreign source income, in order to figure out what their foreign tax credits are.
Part 10, I'm providing the opposite. I'm breaking out the income so that the partner can understand the non-US partner who only has to file a US tax return if they have US source income, I'm breaking out the income so they could see what's US source, what's ECI, which is going to cause them to have a filing requirement versus FDAP, which is not. This is where I'm giving them all of that information.
If I have foreign partners, this is the section that I'm providing to them, this is it. For those of you that were asking, "What do I do if I'm only filing the K-2 or K-3 because I have the foreign partners?" This is the section that you're completing. If all you had was foreign partners, you're even a US partnership, but all of your partners were foreign, this is the section that you would complete. Again, it comes very similar to the part 2 and part 3, which is why I like to view them together. Also, what I like to tell my preparers when they're preparing the K-2, K-3 is that the buckets should be fairly similar. If it's ECI, it's going to be in the general bucket or it's going to be in the US source bucket, but if it's foreign source and it's not ECI, meaning there's some sort of similarity, it doesn't work 100%, but it's the same concept. If you put the two together, they should be in line with one another.
First of all, you have to complete the part 10, not just if you have foreign partners, but if you're not sure if you have foreign partners or if you have an indirect partner. As soon as you have a partnership as a partner, even if they're a US partnership, they might have foreign partners and therefore you have to complete part 10 too. A lot of times, what you're going to end up seeing is that part 2 and part 10 are the two sections that are definitely completed on the K-2, K-3 and you're going to get both. When we talk about figuring out what's relevant for you, you're going to get as a tax preparer of an individual tax return, if you're doing a US 1040 and you get the K-3 and it's part 10 is completed, you can ignore part 10.
On that same respect, if you are a foreign individual and you're completing the form 1040 NR, and you get the K-2, K-3, you can ignore part 2. A lot of times we're going to see both on a K-2, K-3, there's times where maybe all the partners are foreign, there's not one US partner, so then you're just going to see part 10, but like I said, there's times where if you have an indirect partner, you're required to complete part 10. Anytime you have a partnership as a partner, you have to complete part 10. That's it. You're not exempt from completing part 10. That's again the IRS's definition of relevance versus mine. So you're going to see part 10 a lot, but the two, like I said, are quite similar. Some of the biggest differences are you don't have to break it out by country on the part 10 because they don't care about the foreign income.
Here we're trying to tell them what's a US source so that they can file their 1040. They don't care if it's other types of income. Now, we're giving them partner determination because partner determination, they have to determine if it's US or if there's a foreign source. We're giving them the ECI, FDAP, which they might not need to file a tax return for FDAP income if we did our withholding properly, but we're still going to give them that information, other US source income. I'm not sure what doesn't fall under either US ECI or US FDAP, but if there's other US source income, and then foreign source income. It is very important that you understand that breakout.
Now someone said, "Am I saying everybody needs to complete the part 10?" I'm not saying everybody needs to complete the part 10. I'm saying everybody that has a partnership as a partner or doesn't know if their partners are US or foreign has to complete part 10. Now, the IRS told us in the instructions that we can rely on the W-8s and the W-9s received by the partners. If they tell us that that they're not foreign, we can say "That's good enough. I don't need part 10." But sometimes for some reason I can't get my hands on the W-8, the W-9, which is really bad situation. I'm not advising that. But if there's some reason I have no idea if this partner is US or foreign again, why would be in that situation? I'm not sure. But let's say I don't know. Then I would need to complete part 10.
On that same regard, if I have a partnership that is a partner, meaning I'm a partnership and I have partners that are partnerships as well, they might have partners that need part 10. I have to complete part 10 as well. If all of my partners are US individuals, all I have are US individuals and nothing else, I don't need to complete part 10. But yes, a lot of people are going to complete part 10, even if they didn't need it. It doesn't necessarily seem logical to us that they need it.
Again, that goes back to my what's relevant and what the IRS thinks are relevant is not the same. What I receive from the partnership when I'm preparing a tax return is not necessarily what I'm going to use on my tax return. A lot of that stuff for me is going to go in the garbage. All those hours of work that I elected, not necessarily going to need it.
Then somebody else just adding, I'm going to go back to explaining this in a minute, but I think that we have enough time and I want to make sure that I am addressing questions, because it's so complicated. Someone said that they should build in the table in Excel with their partners and make sure that it has all that information, because you have no ... is it a corporation? Is it this? Which parts would it be?
I've seen checklists where you go through for each partner and it would highlight if it's something like that that would tell you this part's necessary, this part's necessary. Yeah, there's all different ways that you can organize it, but yeah, this also puts us in a situation where we really have to make sure that our ducks are in a row, meaning as a preparer of 1065, I need to make sure that I have those W-8s and W-9s, because I don't want to complete part 10 if I don't have to. All of a sudden I really am going to want to make sure that I have that information, that my ducks are in a row, that I know exactly what's going on so that I can make the right decisions about which sections of this form I'm going to complete. Because again, it gets super complicated.
Again, we were looking at section 1 is gross income, section 2 is deductions and losses, and then it's going to obviously bring us to the net income, which should match to the taxable income provided to the partner. We've got everything going on the different sections. If I am filing a 1040 NR or an 1120 F, I'm looking at US source ECI, US source FDAP and US source other, possibly partner determination. I'm going to see what goes on my tax return based on looking at part 10. I'm trying to think if there's anything else.
Right now, there's also this section three. Section three I think throws a lot of people to the loop. First of all, you don't have to fill out section three unless you have ECI. That's number one. Even if you filled out part 10 and all the other sections of part 10, you don't necessarily have to fill out section three. Now, section three is what's needed for a foreign corp that's filing 1120 F to calculate the branch profit tax.
Again, keep in mind that even if you're preparing it, you're the tax preparer of a 1040 NR, and so you get your K-1 and you immediately flip to part 10 so you could see what you need to pick up on your tax return, you don't need section 3 if you're filing a 1040 NR, part 10 section three. Only the guy that's filing the 1120 F that wants to figure out what their branch profit tax is, is the one that needs the section three. That's going to give them all the different ... the branch profit tax is quite complicated, specifically when you're trying to figure out what their US assets are when you need to look through other partnerships to figure out what your US assets are.
That's where you're going to see that they're going to give them the information of what their US assets and US liabilities are and other sourcing information that's going to be needed so that they can figure out what their US based assets are when factoring in their branch profit tax.
Again, I'm filing a 1040 NR. They provided me section three, I don't need it and I don't need to be like, "Oh my God. What am I going to do with this?" I just don't need it. That's what you have to get used to with this form. They're going to provide information that I don't need. I just have to know what do I need and what do I don't need. If I don't need it, just don't need it, I could just here, I'm done. I don't need it. We're really getting almost to the end. I actually didn't get all the way to 5:45, but we'll see if there's more questions.
Part 11 is the section 871 (m), cover partnerships. This one fits in for me very similar to the BEAT. How many of us actually see this? This is specifically for partnerships that have equity derivatives or US source equity derivatives. It's some security that I also not my specialty, it's different types of securities. I can't even really give you too many details about what it is. You would only need to complete this if you have these US equity derivatives and you're a covered partnership, which is a covered partnership, has to be a PTP, which means it's a publicly traded partnership.
You're not going to see Ayelet Duskis, who does financial services and is preparing K-1s for a bunch of venture capital funds and private equity funds is not going to ever have to complete a part 11, because I'm not a publicly traded partnership. You're going to see this on the K-1s that you're going to receive from Morgan Stanley or something like that. You only have to complete this if at least 25% of the partnership's assets are US derivatives or the partnership holds $25 million or more in these US equity derivatives.
Again, this is one of these sections, I don't think you're going to see it a lot. It's used to calculate this 30% withholding tax on the equity derivatives. Again, this is the one section I don't know too much about either. I've never actually completed it and I don't know how many times you're actually going to see it, but you might. Then we've got part ... I like the laughing face emoji someone just gave me because there's so much more of that.
Then we got part 12, which is reserved for future use. The IRS likes using reserve for future use. They leave it all around the form in all different places. Clearly, they have plans for what they're going to add. I hope that that means they're going to make it better or they're going to make it stronger. I don't know if that's what it means, but they could. Before I move on, I'm going to circle back to just a question that someone asked. "What type of income would typically be classified as US sourced other versus ECI or FDAP?"
I'm not sure to tell you the honest truth. It's a catchall, but I don't know what would sit in US source other that wouldn't be considered ECI or FDAP, because FDAP basically covers all the passive income and ECI basically covers all the business income. It's a good question. It's a good question and I believe it's a catch all.
I can open up the instructions on the form and take a look, but it's a catch all basically. All right, that's the end of the K-2, but that's not the end of the K-3. Just when you thought it could get more complicated, you're like "Ah phew, I'm done." No, part 13 is only on the K-3, it's not on the K-2, and it's really complicated in and of itself. As I'm sure many of you know, when a foreign partner has a deemed sale or a transfer of its partnership interest on this schedule, like a foreign partner got rid of let's say this US partnership that had ECI or even a foreign partnership that has ECI, there's withholding that has to get done on the ECI.
In this situation, you're only going to complete this if you know that the partner was foreign and they transferred their interest. If you've had secondary transactions, so partner A sold their interest to partner B, there's going to be a withholding because there was ECI or if the partnership transferred its interest, it had some secondary transaction and there was withholding there, because there was some sort of ECI, then you're going to complete part 13. It's going to basically give all the information for the partner to figure out whatever it's gain or loss on the sale of the transfer of the partnership interest is. Again, remember this isn't on the K-2.
Before I move on, I really want to hear more questions. I know that this was really complicated. I know that many of you're asking to see numbers, but we do have time before this class is over. I have a little bit more to add, but if people have questions, I would really love to hear them. I guess I went faster than I thought, so maybe I talked too fast. But please think about it. Please know that we have time, so give me your questions and while we're at that, we'll get to a polling question.
Astrid Garcia: Polling Question #10.
Ayelet Duskis: Anybody? This is part 13, so there's part 13 up here on both the schedule K-2 and the K-3. Tell me "Yes" or "No."
Also, if anybody wants to write in the comment section, if there's another section of the form that you want me to flip back to, since we finished a little bit early, I can flip it back to any section of the form and we can go through it in more detail. If you don't have a question, feel free to say, "Can we just look at part 3 again? Can we just look at part 7 again?"
Whatever. Let me know what sections you think that you would want to talk about for another few minutes.
Astrid Garcia: Okay, we have a couple more people that need to submit their answers. Just make sure that you guys hit the submit button and I will close out the polling question now.
Ayelet Duskis: Perfect. All right, the answer is, is that part 13, the answer is "No". Part 13 is only on schedule K-3, it's not on schedule K-2. That's the section that you're doing withholding for the foreign partners when there's ECI that we were just talking about. That one, it's individual for partners. There's no partnership amounts. That's why it only goes on the K-3 instead of the K-2.
On that note, we're going to talk just for a second about the 1065 K-3 versus the 8865 K-3. First of all, when would you need a K-2, K-3 on an 8865? You would specifically need it when you're a category 1 8865 filer, meaning you have a controlled foreign partnership. I know we always talk about CFCs, but we also have the concept of CFPs. When I'm a controlled foreign partnership and I'm completing an 8865, it also means I'm going to provide a former K-1 along with the 8865 that the partnership is then going to pick up as income on their tax return.
That section, that when you're that category one. We're not talking about category threes, where it's just to say, I had a contribution to a foreign partnership, et cetera, et cetera. But when you're that category one, where you're providing the K-1s and et cetera, that's where you are going to see a K-2, K-3 on the 88-
... 65. You're going to see a K-2, K-3 on the 8865. Our tax returns have gotten so big, it definitely can be very overwhelming. Now the 8865 K-2 and K-3 is a little bit smaller. It doesn't have all the information. Now, think about it. If there's PFICs in the underlying partnership, and it's a controlled form corporation, and the partnership is including an 8865 with their return, then the PFICs, they'd have to complete Part VII on the 8865, and then, they're going to complete Part VII again on the 1065, so complicated, but yes. But there are a couple of sections that are not really relevant.
One section that's not relevant is Part VIII, the Part IX60 indirect foreign tax credits, because again, those are specifically for the CFC. Part X is not really relevant because if you're filing an 8865, you are the partner, and you are not a foreign partner, if you're required to file an 8865. They're covered partnerships. Again, the 8865, it's obviously not a PTP. It's obviously not a publicly traded partnership, so that's not there.
Then that last section, the section XIII, which is the withholding, the gain or loss on the sale or the transfer, the partnership interest, that also is not going to be there. All of that is the big difference between the K-2 and the K-3. Now, before I go to polling question number seven, I'm going to go look at some of your questions. I think a really good question... all your questions are really good. Give me a few seconds, but somebody asked that we go all the way back to the beginning. If I go all the way back to the beginning... all right, one second. I can select the slide. I think I knew that. There we go.
All right, so I'm going to go all the way back to the beginning, and go through each section, and just remind you who needs to complete what section. If I know it by heart, we'll see. Okay, so remember Part I, anybody would need to complete if any of those items are relevant for them. Part I is all that extra information. Part II and Part III, if you have anybody in your partnership, regardless of if you have ECI or not ECI, if you have anybody in your partnership that is eligible to take a foreign tax credit, you've got to complete Part II and Part III. Now, there are sections in Part II and Part III that might not be eligible for you. You might not have research expenses. You might not have 743b or whatever, so you might leave out that section of Part III, but you would need Part II or Part III, as long as you have any partner that would be eligible for a foreign tax credit.
The same thing... let's say all your partners were partnerships, you have no idea what their partners are. Also, the same with Part X. If you have partnerships as partners, you're going to complete Part II and III and Part X. Just keep that in mind. Part IV is... let's see if I know it by heart. Part IV is the FDII. You only need to complete the FDII if you have corporate partners. If you don't have corporate partners, don't worry about FDII. Part V is the distributions from the farm partners. You only need to complete Part V if you have partners that are US shareholders, that... of a` CFC. You're only completing it if the partnership itself has a CFC, and you have partners that are US shareholders. Okay?
There's a lot of hoops to jump through, because even though sometimes there's a CFC, you've got to have partners that own more than 10% in that CFC themselves, in order for Part V to be relevant. Part VI, the same. Part VI is the GILTI information. Part VI, you're only going to complete... again, if you have US shareholder partners. If you don't have US shareholder partners, there's nobody to give the GILTI and the Subpart F information to. You don't have to complete it.
Part VII is the PFICs, my favorite one. Part VII is the PFICs, and you only have to complete the PFICs, and basically everyone has to complete the PFICs. The only time you don't have to complete the... obviously if you don't have PFICs, you don't have to complete the PFICs, or if you're a US partnership, and you have a valid, pedigreed, QEF, or mark-to-market election in place, that is when you don't have to complete Part VII. Part VIII goes back to the Part IX60, the indirect foreign tax credit, so again, you only have to complete that if you have US shareholder.
Also, I'm saying US shareholder, assuming everybody knows what US shareholder means. US shareholder is a... indirect in this situation, shareholder of this CFC, of the controlled foreign corporation, they have to have at least 10% in the CFC. Even if the entity's a CFC, because I'm a US partnership, and I own 100%, if all of my partners, even if they're all US people, only own 1%, they're not US shareholders. As long as there's one partner that owns 10%, he is a US shareholder. He needs to file GILTI, he needs to pick up the GILTI and the Subpart F income, and all of that et cetera. Then he's going to need Part V and Part VI and Part VIII, and that's when I'm going to provide all of that information.
Part IX... some of them I don't know by heart. Part IX is which one? Part IX is the beat, that's why I don't know it by heart. You only need to complete Part IX if you have corporate partners, and at least one of your corporate partners has more than $25 million of their value, of their interest in the partnership, is at least $25 million, on the last day of the tax year. Again, not one you're going to see very often. Part X, that's our ECI FDAP section and that basically... everyone, as long as they have indirect foreign part... as long as they have partnerships as partners is complete, otherwise it's going to complete it if you have foreign partners.
Part XI is for the PTPs that have... right? Part XI is for the PTPs, one second. Yes, Part XI is for the PTPs with a covered partnership. Again, you're not going to have to complete Part XI unless you're that, and then you have reserve for future use, because that's Part XII, and they don't have Part XIII here. But if you go over here, you'll see that Part XIII, on line 13, that one applies if and when the partner itself is a foreign partner, and he had a transfer of his partnership interest, and it was ECI. Again, a very specific need for that. It's not going to be all the time. I hope that maybe gave you clarity.
Again, what makes the most sense, and what I do, is I have a checklist and I go through, "Do I have this? Do I have that? Do I have this?" If I don't have any US shareholders, even if I have a CFC, I know that there's a bunch of sections I don't have to file anymore. It's a little Excel that another one of my counterparts in the firm prepare, that we just use as a checklist. Okay? That's done. I don't need that one, but it can be very complicated. Yeah, you see that I know it by heart, and like I said, I know it by heart, because I do it a heck of a lot, but that doesn't mean that it's easy. Also, always when in doubt, I know all this information, because I read the instructions to the forms. I love taxes. Anybody that knows me knows that, but I'm not the person that necessarily is sitting there reading code, day in and day out. I'm not a code person, I'm an instructions' person. I read the instructions to the forms.
If something's not clear, I open up the code. But normally most of this information that I got is from the instructions to the forms. If you're really not clear about something, usually if you go to the instructions for the form, they'll clarify it for you. Sometimes they'll say, "As per IRC code section, blah, blah, blah, blah, blah." That's when you're like, "Okay, what is that? I better open up the code section and figure it out." But a lot of times you can actually just get this information from the code. If look at the code, if you look from the instructions, if you look at the instructions to the form, every single one of these sections, when it gets to it, the instructions tell you if and when you need to include this section on the K-2, the K-3.
All right. Another really good question that I saw is if there's one US partner, one non-US partner, will the amounts on section 10... on Part X, be the same for both the K-2 and the K-3? That's also an interesting Part. Specifically for Part X, generally, once you're including Part X for one partner, you're going to include Part X for other partners. The question was if not all of my partners are foreign partners basically, am I including the Part X information for them? Once you include Part X, you include Part X for everyone. That's basically, generally speaking, how it works.
Let's see what else we got. All right, one second, so many good questions. Okay, another great question. If this is like a New York Real Estate partnership... if this is a New York Real Estate partnership that has a foreign partner, would you be required to do Part II? If you're a New York Real Estate partnership, you have no foreign source income, but you have only foreign partners, you just need to do Part X. My earpiece fell out. If you're a US partnership that has US partners and foreign partners, and only US sourced income, you still need to fill out Part II and III, and Part X. Again, it's not... Part II and Part III is not about if the partnership itself has foreign sourced income. It's about if there are partners that are eligible to take the foreign tax credit. Think about it like this. If you're eligible to take a foreign tax credit, you actually need to know all of your income, not just your foreign sourced income, because the foreign tax credit is calculated based on percentage of foreign income over total income.
Theoretically, the partner needs that information to know how to calculate their foreign tax credit, because maybe you don't have foreign source income, but maybe they get another K-1 that does have foreign source income, or maybe they themselves have foreign source income from somewhere else. You would need to be completing Part II and Part III for any US partner. Now, if you only have foreign partners, and even if you have foreign source income, you don't need to complete Part II and Part III, you would complete Part X for your foreign partners. If you actually only have foreign partners, the only sections that you would see completed really, are Part X and Part XIII. Just keep that in mind. I know people asked, "Well, how is this relevant for?"
This form is supposed to be all-inclusive, so it's covering almost every scenario that you would see, and that's part of why sometimes you see X, and sometimes you see Y, and this section is eligible for this section, and this section isn't. The sections for foreign partners would be Part X and Part XIII. US partners, it's so much more extensive, because the US partners might have to go with PFICs, and the US partners might be US shareholders, but again, we can knock out three sections right there, if we know that there's no US shareholders. It takes keeping in mind, getting used to again, looking at the forms, just reading the instructions to the form, to ask yourself if I'm even required to do this. If I don't have a CFC at all, which many partnerships don't have CFCs, I also know that I automatically got rid of three sections. If I don't have PFICs, I also automatically got rid of some sections. Sometimes it's clear when I need to file something, and sometimes it's not, and when it's not clear, that's where the instructions to the forms are very, very helpful.
Let's see. All right, so I'm going to... there seems to be a bunch of questions about Part II and Part III. Let me move to Part II and Part III for a second. Let's pretend very easily that I'm a partnership that performs services. I'm a US partnership. I have US partners. I don't have any foreign source income. I perform services. Let's pretend that I have $100 of service income, and I have $50 of expenses, and my net taxable income was $50. I'm going to make it as simple as humanly possible. If you look at Section 1 of Part II, I'm going to go to Section 2... box 2, gross income from the performance of services. In this case, this is going to go in column A, which is US sourced. On line A, I'm going to write US, and I'm going to put $100.
Let's say I had capital gains, I don't have that page here, but on the next page there's a spot for capital gains. Let's say I had service income of the $50, the gross of the $100 and the $50 of expenses, I also had capital gains of $50. On the capital gains section, I would put the same, I'd put xx, because remember capital gains is sourced by partner. I'd go to column F, and I'd put the $50. Then I'd get to Section 2, which is the deductions. On Section 2, I have line 26, expenses eligible to gross income from the performance of services. If I look there... now, remember I said I had $100 of gross service income, and I had $50 of expenses, that was directly related to that service income. I paid my employee who provided the services, and again, it was US sourced.
Everything's US sourced, here. I'm making it very simple. I'm going to put my 50 bucks over there. Now remember, I had taxable income of $50, from my $100, minus my $50 of expenses, and then a $50 of capital gains. My total taxable income was $100. On the next page of Section 2, which again I don't have here, because I couldn't give you a screenshot of every single line item, or it would've been like 5,000 pages long. There's actually a spot for a total, and that total in the end is going to tie to my taxable income, that I provided to the partner, except in one instance. When I have foreign taxes paid, that are eligible for a foreign tax credit, they weren't included anywhere on this income or deduction section, because remember on my 1116, they're not going to be included in my calculation of what's a US versus foreign. Those are going to be included.... they're going to be included separately.
You're going to see that in Part III, Section 4, where I'm going to put my US... I'm going to put my foreign taxes pay. In general, when you're finished Part II, Part II is going to line up with whatever your total taxable income was on your K-1. It should line up. If it doesn't line up, the only difference should be foreign tax credits. If it still doesn't line up, either there's a rounding issue, or there's a mistake, so keep that in mind. We do sometimes include a footnote, because it can get really complicated with the rounding. We do sometimes include a footnote that says, "You might be a few dollars off because of rounding." Maybe if something's $3 or $4 off, I've gotten K-2s that somebody else prepared, where I see that they had taxable income of 50 bucks, and this says 75, and there's no foreign taxes paid. Clearly, like I said, the forms are so new we still don't know what we're doing, which is okay. That's where it gets us. It's where it puts us.
Now, if I follow from the same thought process, let's pretend I have the same scenario. I've got the $100 of US source income, the $50 of gross income, the $50 of expenses, and the $50 of capital gain. I go to my Part X, and that's why I say that I like to do these sections in tandem, because I do think that there is a lot of similarity. I think this is it.
If I go to Part X I have... you can't see it, but it's under here. I'm going to have a line for gross income from services. First of all, I'm going to put my total in column A, my total gross. I don't have to put my country anymore. My total gross income was $100, and my total gross income is US source. In column C, I'm going to put $100 dollars. Then I'm going to go to Section 2. Well, then I have capital gains again, remember, so then I'm going to put the $50 of capital gains, in the line that's applicable to capital gains. A is going to be my total of $50. Capital gains are partner determination, so they're going to be in column B. Then I'm going to go to Section 2 and I'm going to put my $50 of expenses again on the line... I don't know, I think it's line six or so, the $50 of expenses. Again, it's going to go, the total is going to go in A, and then it's going to go in column C, US source ECI.
Now, when I'm the foreign partner that looks at this, and I know that capital gains are sourced based on my residence, and I am a foreign partner, I'm not a US resident, I'm going to say, "Ha ha, great. I'm not worried about the capital gains. There was $50 of capital gains. I don't care." But I'm going to look at column C. Column C is really important to me, and when I file my 1040-NR, I'm going to pick up the $50 of income. That's why I'm filing my 1040-NR. On that same respect, that $50 of income should match with the 8805 that the partnership gave me, because they withheld on my ECI. Because remember, partnerships have to withhold when they have ECI to foreign partners, the same way that they would have to withhold if there was FDAP income.
There's a lot of overlap, which is why in some ways this became too much, because it's like, "Wait a minute, but I have an 8005, I already gave them the information. Why am I also giving them now the information on Part X." But just know that Part X is where they're expecting you to get that information, versus 8005, where they're really just expecting to know how much US taxes they've paid on your behalf. That's also a important item to understand, and that's why I like to... like I said, I like to do the forms in tandem, because if it's US source there, it's US source there. Now if it's FDAP, here, we have to break out between US source ECI and US source FDAP. Why do we have to break out between US ECI and US source FDAP?
Because a foreign partner, as long as the withholding was done correctly on FDAP, they don't have... on a 1042, they don't have to file the 1040-NR or the 1120-F. If there's ECI, they have to file the 1040-NR and the 1120-F, but if it's FDAP, they don't. That's why here it's important that it breaks it out, versus the US partner, as long as it's US source, they don't care if it's ECI or FDAP. It goes in the US bucket. It's going to help with their... it's going to reduce their percentage of foreign source income. That's really all they care about. There are differences based on the differences in who needs the information.
Another way to look at it to help, when you're trying to understand it, is how is the information being used by the person who receives it? Again, I know that if I'm looking at this form, I know that it's really, really important that they know what's ECI, versus what's FDAP, because they're trying to figure out what they're going... what's going on in their tax return, versus when I go to Part II and Part III, and I know that that's for US partners. That's where the US partner, again, is trying to figure out what's their total income bucket, total income over their foreign... what's their foreign income over their total income, to get their foreign percentage, so they could figure out how much tax credits... foreign tax credits they're eligible for. It's a different use.
Again, the forms I think they follow each other. What's ever in the partner determination in one place, is going to be in the partner determination in the other place, they follow each other. They have some similarities, but their uses are different, and that's why they look different. If you know their use, it should help you understand it a little bit better.
Let's see what else. We are now at... okay, so someone else asked a really interesting question. What does foreign source ECI mean, and why does it matter? Foreign source ECI... I did look this up. This was one of the things that I had to go outside of the instructions to the form. Foreign source ECI has to do with branches. When you have a foreign branch that has income, it could be ECI, because it's a branch, that's where... that's what foreign source ECI is. Does it matter? I'm not 100% sure if that foreign source ECI is taxable, as ECI to the foreign partner. I would have to look that up. But so you know, the foreign source ECI is basically when you have a foreign branch of an entity, that is doing... that is generating ECI.
Another good one, somebody said we could see sometimes capital gains are ECI, because you can have sales of real estate 1231 or 1250, so yes, not all capital gains. Sales of stock are going to be partner determination, but sometimes other sales are also going to be considered ECI, and we're going to need to file a foreign tax return for a 1040-NR for that also. That's specifically if we go back to our sourcing cheat sheet, specifically when we go back to the cheat sheet, anything that is US, or anything that would be US source, like we said, sales of real estate, all of those sorts of things would also be capital gains, so to speak, but they would be ECI. It's a very good point. Thank you for adding that.
All right, so I'm going to go back to the PFICs for one second, and I think after that we'll get to the end. I want to say you guys are a great audience, great questions, lots of good emojis, but it's weird that I can't see your face. People ask me to review the PFICs again, I don't know which parts of the... and I'm getting clapping emojis, so I guess you guys are happy to talk about PFICs. All these people after my own heart. I'm not sure which sections of the PFICs were not clear, or as clear, as well. Oh my god, somebody's given me a lot of party emojis over here, "Woo hoo, PFICs." But yes.
First of all, there was a question when we go to the pedigreed, what are the pedigreed QEF and the pedigreed mark-to-market? Pedigreed is specifically when you didn't have to do any sort of... sometimes we do something called a purge, where day one we didn't make a QEF election, or a mark-to-market election, and we want to make it in the future, so we'll do a purge election, treat it as if we sold it that day, 1291, and then make the QEF election. If that happened, it's not pedigreed. Any other situation where maybe it's not clear that it's just a straight-up QEF, in a situation where like I said, we have the, "Once a PFIC, always a PFIC," unless you've made a QEF election. But it's got to be a good QEF election on day one. If there's any sort of situation where it wasn't a good QEF election on day one, it's not a pedigreed QEF.
The instructions to the 8621... like I said, I'm a real instructions' person. The instructions to the 8621 actually go into all the detail about what pedigreed and not pedigreed is. Every time I look at it, I just think about dogs. I can't help it. That is mainly what that is. Again, if I have a QEF election now, but it was a purge election, I'm still going to include the information over here for the partners. Then I'm even going to put in box J that I made the QEF election.
All right, two more seconds about this form. We went through this section in detail, but let's go to the 1291 information, and then after this I'm going to take you to that final polling question. The 1291 information... like the QEF income, I think it's fairly... not obvious, because PFICs are obviously very hard, but we know when we're making a QEF election, we know that we have to get a statement from the PFIC that says we can inspect their books and records, and what our share of ordinary earnings and net capital gain is. In my practice, most of the time we write those statements, we provide them to the PFICs, they sign them, and we keep them on record, and then we give the information over to the partners, of the partnership.
We know that ordinary earnings can never be zero or lower. With a QEF election, you only pick up income, you don't get losses. We still break out capital gains, they still can get their special rates treatment, the capital gains. They're still subject to the 1-3 years if there's any carried interest, so there's all different... that's QEF. Mark-to-market election, so we're going to do the fair market value of the PFICs on day one of the year, and the fair market value of the PFICs at the end of the year. Now, if I have a mark-to-market election, that means that this is a marketable stock, so I'm not getting the fair market value, I've got the fair market value, because it was sold on a marketable exchange. You do that... so when I do that... so what's ever the last day of the year, the next year is going to be at the first day of the year, and if there's an increase over there, the partner that's making the mark-to-market election picks up that increase in their own tax return.
1291 it's a whole other bear. Again, this is not a PFIC training, and I can go into a whole huge PFIC training, but it's important that you know that when you're doing 1291... when you're subject to 1291, there's all these different pieces. But the first and biggest... most important piece is, is this an excess distribution? An excess distribution is more than 125% of my average distributions over the last three years. That's why this becomes a real headache, because it's not just what my distributions were this year, it's what were my distributions for the last three years, and that's what I'm going to put in column K. Then I'm going to give them my distribution for this year, so they can calculate if there's an excess distribution. All of that is on 1291.
Again, I'm happy to talk about PFICs for days, and days, and days, but I don't want to go into all of the little details. If anyone has a question, and they could... happy to reach out to me personally. On that note, you guys had some really great questions, and I was very happy to answer them, and great crowd. Really glad to be back. I'm going to take you to the last polling question.
Astrid Garcia: Polling Question #11.
Transcribed by Rev.com
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