On June 3 and 4, 2021, the IRS released final versions of new Schedules K-2 and K-3 that are being added to passthrough entity returns (Partnerships and S Corporations) filed for the 2021 tax year:
- Schedule K-2, Partners’ Distributive Share Items — International
- Schedule K-3, Partner’s Share of Income, Deductions, Credits, etc. — International
In addition, the IRS recently released FAQs regarding the updated schedules. These FAQs help clarify the initial guidance and address outstanding questions from taxpayers who are impacted. The FAQs can be viewed here.
Schedule K-2 will report the partnership/S corporation-level activity attached to a flowthrough return, while Schedule K-3 will be provided to each partner or shareholder and report its proportionate amount for each item. Draft Schedule K-2 and K-3 instructions were released by the IRS on June 30, 2021, but questions remained as to how to approach the new requirements without incurring penalties.
As with any new guidance, the detailed 2021 Schedule K-2 and K-3 instructions will create transitional challenges. In an effort to ease this transition and the uncertainty around penalties, IRS Notice 2021-39 was released, confirming that it will provide certain penalty relief to filers who fall short of the new requirements in tax years that begin in 2021, so long as taxpayers make a good-faith effort to comply.
The IRS also issued frequently asked questions, which were updated to include the following exception and should apply to most partnerships/S corporations with domestic operations (see FAQ Question #15):
- In tax year 2021, the direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts.
- In tax year 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 (see section 1.861-9(g)(3)).
- In tax year 2020, the domestic partnership or S corporation did not provide to its partners or shareholders nor did the partners or shareholders request the information regarding (on the form or attachments thereto):
- Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S), and
- Line 20c, Form 1065, Schedules K and K-1 (Controlled Foreign Corporations, Passive Foreign Investment Companies, 1120-F, section 250, section 864(c)(8), section 721(c) partnerships, and section 7874) (line 17d for 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.
These new schedules are significant (in some cases exceeding 19 pages), especially if there are foreign partners or foreign operations. Schedule K-3 may also include information not previously reported on Schedule K-1 that could lead to additional filing requirements.
International tax compliance can seem like a never-ending maze of continually changing requirements, and updates such as this can feel like a burden for CPAs to keep up with to ensure their clients are filing properly. For CPAs with clients operating globally, they should continue to stay aware of all the changes to the international tax provisions applicable to their pass-through entities and request a complete disclosure by their partners/shareholders of their interests in foreign entities where the partnerships/S corporations have an ownership interest.
It is also critical to know the partners/shareholders and ensure greater sharing of information across tiered partnerships, including:
- 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
Understanding these details will help determine if the new Schedules K-2 and K-3 are required, and if so, what part(s) should be completed. Given the length of the new schedules, avoiding completing any part of the schedules that are not required for your clients will help significantly reduce compliance burden.
At this time, we do not believe that any reporting should be required for IC-DISC related structures regardless of the entities involved. We have also seen that many tax software providers are scrambling to update their software platforms to allow for proper reporting. Continual updates are being provided by each software vendor to ensure that there is a filing option for the 2021 tax filing. We will continue to monitor these situations and provide additional analysis as information becomes available.
These new requirements should not be viewed by taxpayers or tax professionals as restrictive or burdensome if interpreted correctly. Rather, the requirements provide clarity on how to properly report international business activities and help prevent unforeseen compliance penalties.
As these requirements evolve, we advise that CPA firms continue to monitor IRS guidance as they are able and stay connected with your trusted international tax advisor for additional support and guidance. We appreciate your continued trust in McGuire Sponsel as a technical resource to your firm. If you have any questions about this update or other international tax compliance issues, do not hesitate to reach out to our Global Business Services team.
Jason Rauhe, CPA is a Principal in the firm’s Global Business Services practice and is responsible for assisting clients and adding depth in all areas of the firm’s international tax consulting services including transfer pricing, and the firm’s compliance expertise.
Rauhe previously served as Director of International Tax at a Top 100 CPA Firm, where he was responsible for the firm’s international tax division and major industry alliance networks.