New Schedules K-2 and K-3, Form 1065: What Do We Do Now?

September 16, 2021

By Ragini Subramanian

The partners in a partnership and shareholders in an S corporation are familiar with a Form K-1 that they receive each year showing distributive share of income, deductions, and credits from the partnership/S corporation.  In many cases, especially where a partnership/S corporation engages in international transactions, a K-1 comprises of multiple pages of notes, footnotes, directions, references to other tax forms, and other brain numbing details.   Effective for tax year 2021, the partners/shareholders will receive a K-1 and a K-3. 

Did I make a mistake? K-1 and K-3? Do I mean K-1 and K-2?  No, because effective for tax year 2021, a partnership or an S corporation with foreign transactions will prepare Schedules K and K-2 along with its Form 1065 or Form 1120-S and provide Schedules K-1 and K-3 to partners/shareholders. (If an entity is required to file Form 8865 to report transactions related to interest in foreign partnership similar schedules will be prepared with Form 8865.)  Broadly speaking, Schedules K-2 and K-3 are to provide for items of international relevance, while Schedules K and K-1 are to provide for items of non-international relevance.

Examples of items of international relevance that will be reported on Schedules K-2 and K-3 (as opposed to on Schedules K and K-1) include:

  • Foreign tax credit-related information including special apportionment factors related to, e.g., R&E expenses, interest expense, FDII deductions, etc.
  • Share of partner-level international items
  • Foreign partner’s U.S.-source income and/or U.S effectively connected income including distributive share of deemed sale items on transfer of partnership interest
  • Information related to
    • investments in passive foreign investment company
    • interest in controlled foreign corporation, GILTI and Subpart F income inclusion
    • foreign derived intangible income
  • Base erosion and anti-abuse tax provisions

But why two new Schedules K-2 and K-3? According to the IRS, to enable   

  1. pass-through entities (and those required to file Form 8865) to provide a standard format of information of international relevance to the partners/shareholders, (GREAT!)
  2. partners/shareholders to easily translate this information on their own return, (EVEN BETTER!) and
  3. the IRS to verify taxpayer compliance more efficiently (GOTCHA!).

Note that each new Schedule K-2 and K-3 is comprised of 21 pages with K-2 having XII Parts (each with subparts), and K-3 with XIII Parts (each with subparts).  The international transactions are required to be reported in specifically assigned parts I to XII (or I to XIII in the case of Schedule K-3), making it very easy for the IRS to verify taxpayer’s compliance/non-compliance.  A partnership and an S corporation with international transactions must begin looking at specifics of these reporting even where it thinks that it has a handle on its international reporting.  The reason is that the good old days of reporting international transactions in footnotes are gone.  New Schedules K-2 andK-3 assign specific boxes, sections, and parts for specific items of international transactions and in some cases require greater detail. 

So, what should be done now that Schedules K-2 and K-3 are upon us? 

  • Be fully aware of all the changes to the international tax provisions applicable to your pass-through entities and request a complete disclosure by your partners/shareholders of their interests in foreign entities where the partnerships/S corporations have an ownership interest. For example, under December 2020 passive foreign investment company (PFIC) regulations, under certain circumstance after application of “top down” approach to ownership attribution, a partnership/partner may become subject to PFIC rules requiring completion of Part VII (Information to complete Form 8621).
  • Know your partners/shareholders and ensure greater sharing of information across tiered partnerships
    • S. or foreign status
    • Partner/shareholder entity type -- individual, corporation, pass-through entity, disregarded entity, trust, or estate
    • Who the ultimate owners of the immediate partners/shareholders are.

This to not only determine if the new Schedules K-2 and K-3 are required, or what part(s) of the same should be completed; it is also to avoid having to complete the new schedules or any part thereof if not required, thus reducing compliance burden.  For example, if an international transaction of a partnership is otherwise eligible for a foreign derived intangible income deduction to its corporate partner, the partnership is required to provide this information to such corporate partner on Schedule K-3 Part IV (Form 8993 Information on partner’s IRC Sec. 250 deduction with respect to FDII).  If the partnership knows that it has no direct or indirect corporate partner it may decide to not complete Part IV -- a big saving on compliance.

  • Notice 2021-39 provides transition relief from penalty for non-compliance with respect to Schedules K-2 and K-3 if good faith effort is demonstrated. A good faith effort is demonstrated for example in the case of a partnership if the partnership clearly documents
    • the procedures and steps taken to seek all the necessary information from lower-tiered partnerships and all partners to complete Schedules K-2 and K-3.
    • the assumptions used to complete or not complete various parts of the new Schedules.

The documentation can include email correspondence, amended partnership agreements, memoranda that require sharing of needed information, fully completed Forms W-8BEN, W-8BEN-E, W-8ECI, W-8IMY, W-8EXP, W-9[1] in support of U.S. or foreign status and entity type of partner/shareholder, etc.  For example, if a partnership has proper documentation of U.S. status of its partners, and in case of sale of the partnership interest, it may decide to not complete Part XIII of Schedule K-3 as required under 2020 changes to IRC Sec. 864(c) and 1446(f).

  • Partnerships and S corporations should review Schedules K-2 and K-3 compliance not only in the light of penalties associated with incomplete/inaccurate/non-filing but in the context of investor relationship issues and consequences to the partners. For example, if the Schedules K-2 or K-3 do not provide sufficient/correct information to enable partners/shareholders to correctly file their own tax returns, or information is on the wrong schedule (on K-1 as opposed to K-3 and vice versa), the partners may face compliance issues.  Not a good optics for investor relations.  The converse is true for partners and shareholders also.  For example, where a partner in a partnership holding real estate does not confirm it’s U.S. or foreign status, the partnership can be saddled with compliance requirements that it could have avoided had it known that the partner is a U.S. person.  
  • The partnership and partners should also consider consequence under new centralized partnership audit regime, if applicable.[2] Under this regime, the IRS generally assesses and collects any underpayment of tax (called an imputed underpayment or IU) at the partnership level and partners do not have participation right to challenge partnership adjustment. 

In summary, for tax years beginning 2021 and to the extent a pass-through entity has information of international relevance, it will file Schedules K, K-1, K-2 and K-3 with its Form 1065, or 1120-S (if Form 8865 is required). With greater vigilance likely from the IRS, the filer of Schedules K-2 and K-3, as well as partners/shareholders, should work with an accounting firm that understands pre-TCJA and post-TCJA international provisions as well as requirements of various new and revised tax forms that have come into effect since the enactment of TCJA.

TABLE 1:    Comparative Review of Schedules K-2 and K-3 Form 1065 and Purpose of various Parts

Schedule K-2 – Form 1065

Schedule K-3 – Form 1065

Purpose of This Part/Section

Header row – Name, address, and EIN # of partnership

Lines A and B – Name, address, and EIN # of partnership

Identify partnership/K-2, K-3 filer

N/A

Lines C and D – Partner’s name and address

Identify partner/owner

Line A – Is partnership a withholding partnership – Yes/No

N/A

Identify if the filer of K-2/K-3 has obligation to withhold income tax on payments to foreign partners

Line B - Is the partnership a qualified derivative dealer?

N/A

Identify need to withhold if foreign partners. Should review carefully especially if alternative investment partnerships

Line C - Applicable Parts I thru XII of K-2 or K-3

Line E - Applicable Parts I thru XII of K-2 or K-3

Upfront identification of part/s of Schedules K-2 or K-3 completed

Part I - Partnership’s Other Current Year International Information (1 thru 12)

Same Part I as K-2 but represents distributive share of the partner

Various, examples include identify partner level income source, special items related to foreign tax credit (splitter arrangement, identify exchange rate used to convert foreign tax paid to USD), to identify high taxed passive income’s reclassification as general income, outbound investments in a foreign corporation or foreign disregarded entity, loan transactions between partner and partnership, etc.

Part II – Information to calculate foreign tax credit limitation

  • Section 1 Gross income,
  • Section 2 Deductions

Same Part II as K-2 but represents partner’s distributive share in partnership

Purpose is to provide clear data to enable calculation of foreign tax credit and more importantly foreign tax credit limitation

Part III – Other Information for preparation of Form 1116 or Form 1118

  • Section 1 R&E expense apportionment factors
  • Section 2 Interest expense apportionment Factors
  • Section 3 FDII Deduction apportionment formula
  • Section 4 Foreign taxes
  • Section 5 Other tax information

Same Part III as K-2 but represents partner’s distributive share in partnership

Provide clear data to properly source certain deductions claimed on the partnership returns - U.S. or foreign, to correctly calculate foreign tax credit limitation

Part IV – Information on partner’s IRC Sec. 250 deduction with respect to FDII

  • Section 1 Information to determine deduction eligible income (DEI and qualified business asset investment (QBAI on Form 8993
  • Section 2 Information to determine foreign derived deduction eligible income (FDEI) on Form 8993
  • Section 3 Other information for preparation of Form 8993

Same Part IV as K-2 but represents partner’s distributive share in partnership

Should be completed if partnership has a U.S. domestic corporate partner and partnership enters in transactions that may enable such partner to seek FDII deductions under IRC Sec. 250. This part should be completed if the partnership has no clear indication of a U.S. domestic corporate partner. This information is used by a U.S. domestic corporate partner to complete Form 8993 - Section 250 Deduction for Foreign Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI).

Part V Distributions from foreign corporations to partnership

Same Part V as K-2 but represents partner’s distributive share in partnership

To enable eligible partner to exclude previously taxed income (PTEP) and report currency gain or loss related to PTEP income on eligible partner’s Form 1040 or Form 1120.  The eligible partner will need associated Form 5471 to prepare its Form 1120 or 1040

Part VI Information on partner’s Section 951(a)(1) and Section 951A inclusions

Same Part VI as K-2 but represents partner’s distributive share in partnership

If the partner is subject to GILTI income inclusion, this section provides information to calculate amount to be included in income and prepare Form 8992 – U.S. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI).

Part VII Information to complete Form 8621

Same Part VII as K-2 but represents partner’s distributive share in partnership

To provide consistent information needed to enable partner to prepare Form 8621 unless partnership has filed this form on behalf of the partners

Part VIII Partner’s interest in foreign corporation income (section 960)

Same Part VIII as K-2 but represents partner’s distributive share in partnership

To enable corporate partner to calculate deemed paid credit on Form 1118 – Foreign Tax Credit Corporations. To enable individual partner to decide whether section 962 election should be made to claim deemed paid foreign tax credit on Form 1116 – Foreign Tax Credit (Individual, Estate, or Trust)

Part IX Partner’s information for Base Erosion and Anti-abuse tax (section 59A)

  • Section 1 Applicable taxpayer,
  • Section 2 Base erosion payment and base erosion tax benefits

Same Part IX as K-2 but represents partner’s distributive share in partnership

To help corporate partners determine if they are subject to BEAT provisions of Section 59A

Part X Foreign partner’s character and source of income and deductions

  • Section 1 Gross income
  • Section 2 Deductions, losses, and net income
  • Section 3 Allocation and apportionment methods for deduction

Same Part X as K-2 but represents partner’s distributive share in partnership

To provide foreign partner with information to complete Form 1040-NR or Form 1120-F

Part XI Section 871(m) partnerships

Same Part XI as K-2 but represents partner’s distributive share in partnership

To be used by certain partners to determine their U.S. withholding tax and reporting obligations with respect to IRC Sec. 871(m) transactions)

Part XII Section 871(m) tax liability of qualified derivatives dealer (QDD)

Same Part XII as K-2 but represents partner’s distributive share in partnership

To be used by certain partners to determine their U.S. withholding tax and reporting obligations with respect to IRC Sec. 871(m) transactions)

N/A

Part XIII Foreign partner’s distributive share of deemed sale items on transfer of partnership interest (IRC Secs.  864(c)(8) and 1446(f)

This information is to be provided to a foreign partner who is the transferor of interest in a partnership that is engaged in a U.S. trade or business.  The information helps the selling foreign partner to calculate taxable gain under IRC Sec. 864(c)(8) and seek refund of tax withheld by the transferee under IRC Sec. 1446(f)

 


[1] Form W-9 – Request for Taxpayer Identification Number and Certification; Form W-8BEN - Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals); Form W-8BEN-E - Certificate of Entities Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities); Form W-8ECI - Certificate of Foreign Person's Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States; W-8IMY - Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding and Reporting.

[2] Partnerships with 100 or fewer partners for the taxable year can elect out of the centralized partnership audit regime provided all its partners are eligible partners.  Eligible partners include individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, S corporations, and estate of deceased partners.  Eligible individuals are calculated by adding total number of K-1s issued by the partnership and including all shareholders for any partner that is an S corporation.   

About Ragini Subramanian

Ragini Subramanian is a Tax Senior Manager in the Personal Wealth Advisors Group.