The Latest IRS Schedules K-2 and K-3 Guidance -- Burden Lightened but Not Eliminated
February 23, 2022
By Matthew Talia and Philip Bekmessian
When the IRS announced that new Schedules K-2 and K-3 would be required for pass-through entities to report items of international relevance, the tax community worried about the administrative, financial, and tax risk ramifications of implementing one of the largest changes to international reporting in recent memory. As more guidance and instructions were released, the angst reached a crescendo. While the effort to reach the goal of providing consistency for how items of international relevance would be reported was welcomed, the implementation of these forms during a compressed tax season, as well as voluminous instructions, left many wondering if this could be implemented for tax year 2021 in an accurate, fair, and efficient manner.
The new Schedules K-2 and K-3 were created to provide a standardized method of reporting items of international relevance to partners, shareholders, and the IRS. Previously, items of international tax relevance were aggregated and reported on Schedule K, Line 16 (Line 14 for s corporations) and through footnote attachments with little consistency. Prior versions of Schedules K and K-1 did not require pass-through entities to provide this information in a specified format. The implementation of Schedules K-2 and K-3 is intended to reduce those inconsistencies and assist taxpayers in accurately complying with their own filing and reporting obligations, most notably claiming the Foreign Tax Credit on Form 1116.
Certain data that has not been required in the past, such as the spot rate on the day foreign taxes were withheld and converted to USD, is now mandatory. While this data is attainable, an entity with a substantial foreign dividend paying portfolio will be faced with a challenging administrative task with little lead time. The instructions released with Schedules K-2 and K-3 are complex and have led many reasonable minds to differ in how they should be filled out. How income and expenses should be categorized and sourced by jurisdiction for entities with differing tax profiles is not abundantly clear.
In addition to the burdensome task of gathering information and preparing the complex schedules, the tax community has criticized the IRS regarding the submission and processing of the new forms. According to the FAQ, Modernized e-File (MeF)/Extensible Markup Language (XML) electronic filing capability for the schedules will not be available to begin the 2022 filing season. For taxpayers that are reluctant to extend their returns, the IRS has announced that PDF attachments of the schedules can be submitted electronically with returns. Any taxpayer that prefers to utilize XML to submit the schedules will have to extend their 2021 returns. Tax preparers also run the risk of incorrectly filing the forms before more guidance is released, and tax practitioners coalesce and form industry standard practices. Returns that were previously completed early in the tax season may now linger on extension. The processing woes of the IRS were brought to the forefront during the recent United State Senate Committee on Finance hearing on February 17, 2022. Jan Lewis, chair of the American Institute of Certified Public Accountants (AICPA) Tax Executive Committee, voiced concerns regarding the IRS backlog of processing notices, returns and other filings. The AICPA released a statement suggesting a delay of the forms for at least one year.
The IRS first acknowledged the financial and administrative burden that the new forms placed on tax practitioners and taxpayers alike when it released transition penalty relief through Notice 2021-39 in June 2021. Notice 2021-39 provided that if the taxpayer demonstrated a good-faith effort to comply with the new requirements, it would be afforded penalty relief. Among other conditions, the good-faith effort relief notice requires taxpayers demonstrate changes made to processes, procedures and systems for the collection and processing of information needed to file Schedules K-2 and K-3. While penalty relief was welcomed and appreciated, the tax community did not feel that it was a substitute for proper guidance on who needed to file the forms, and how.
Due to overwhelming feedback received, on February 16, 2022, the IRS updated the filing requirements and released new guidance regarding these schedules. The IRS released a list of exceptions that allows entities which meet the criteria not to file forms K-2 and K-3. Taken from the FAQ, some of these exceptions are as follows:
- In 2021, the direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts.
- In 2021, the domestic partnership or S corporation has no foreign activity, including foreign taxes paid or accrued or ownership of assets that generate, have generated, or may reasonably expected to generate foreign source income
- In 2020, the domestic partnership or S corporation did not provide nor did a shareholder request information on Line 16 of Form 1065 and Line 14 of Form 1120-S
- The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021.
This provides much needed relief for U.S.-based entities, with U.S. partners and activity. Presumably, this will allow them to complete their returns at an earlier date with much less complication. The final bullet point is extremely important because there remains uncertainty from an entity and tax preparer perspective. If a shareholder or partner notifies the entity that it needs information contained on Schedules K-2 and K-3, the entity must provide the information. Further, if a partner or shareholder notifies the entity that they need the information before the return is filed, Schedules K-2 and K-3 must be completed. It would be advisable for an entity who qualifies for these exceptions to reach out to its partners beforehand to confirm whether they need this information or not, instead of having to unexpectedly complete and provide it at a later point.
A potentially overlooked point is the information reported on the 2020 tax return. Entities that reported foreign items of relevance in 2020 but do not have any foreign activity in 2021 still must file the new forms. Also, it must be noted that it was very common for entities which only had U.S. activity to report information on line 16 of Form 1065, and Line 14 of Form 1120-S. If this is the case, there will be numerous entities who would be disqualified from utilizing this exception.
While the entities that would have had the simplest K-2 and K-3 forms have been provided some relief, the forms remain onerous to entities with foreign activity. The instructions and forms themselves remain voluminous and open to interpretation. It is very possible that in the initial year, a shareholder of multiple partnership or S corporation investments will receive forms filled out in an inconsistent manner. This would run counter to the IRS’s stated goal of standardizing the foreign tax reporting process. It would significantly complicate the process of claiming the Foreign Tax Credit once the forms move down the chain to the individual taxpayer. The IRS’s new guidance shows that feedback from tax practitioners has been heard loud and clear, but the question remains whether it went far enough.