IRS offers further K-2/K-3 relief

By Paul Bonner

The IRS provided transition relief Wednesday under which eligible passthrough entities will not have to file new Schedules K-2 and K-3 for tax year 2021. The relief is outlined in News Release IR-2022-38 and frequently asked questions on the IRS website ("Schedules K2 and K3 Frequently Asked Questions" — see FAQ 15).

Affected partnerships are required to file Schedule K-2, Partners' Distributive Share Items — International, and K-3, Partner's Share of Income, Deductions, Credits, etc. — International, with their Form 1065, U.S. Return of Partnership Income. The corresponding forms for S corporations to file with their Form 1120-S, U.S. Income Tax Return for an S Corporation, are K-2, Shareholders' Pro Rata Share Items — International, and K-3, Shareholder's Share of Income, Deductions, Credits, etc. — International.

The schedules, new for tax year 2021, have been the subject of widespread commentary among tax practitioners in the current return filing season, most of it unfavorable. They must be filed by partnerships, S corporations, and filers of Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, with "items of international tax relevance," according to their instructions. The potentially wide reach of that rubric and difficulties inherent in finding and documenting those items have been the focus of much of the practitioners' expressed frustration.

The schedules are intended to make those international items less obscure for partners and shareholders needing the information to file their own returns. In stating that aim, the IRS has previously acknowledged the administrative burden the schedules impose and provided some transition relief last June, in Notice 2021-39.

The relief announced Wednesday applies where:

  • 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 be expected to generate foreign-source income (see Regs. Sec. 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 on the form or its attachments regarding:
    • 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, Sec. 250, Sec. 864(c)(8), Sec. 721(c) partnerships, and Sec. 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.

AICPA members can get the latest guidance and download a client letter in the IRS Schedules K-2 and K-3 guidance and resources library, compliments of the Tax Section.

The IRS said earlier it was taking the step "in response to feedback we received from the tax community and our stakeholders."

The schedules are intended to provide greater clarity for partners and shareholders in computing their own income tax liability with respect to items of international tax relevance, in a standardized format. Previously, such information has been compiled in a variety of formats that may be difficult for partners to translate, the IRS stated. They replace and supplement the often cursory information formerly required to be entered on Schedule K-1, line 16, headed simply "Foreign transactions," which then often necessitated an attached document, but with no specified format or items of information.

In addition, the schedules are intended to help the IRS more efficiently verify compliance.

Practitioners may have felt misled when the IRS posted on its website a revision to the schedules' instructions about who must file them, said Ed Zollars, CPA, tax partner in Thomas, Zollars & Lynch Ltd. in Phoenix and lecturer and author for Kaplan Accounting Continuing Education, who has written about the issue. 

They may have construed the previous instruction that partnerships with no "items of international tax relevance (typically, international activities or foreign partners)" to mean that if they lacked foreign partners or foreign activities, they need not file.

But in a note on a webpage on Jan. 18, 2022, revising the partnership instructions, the IRS said that despite having no foreign-source income, assets generating it, and no foreign taxes paid or accrued, a partnership may still need to file the schedules if, for example, a partner claims a credit for foreign taxes the partner paid. Also, even if a partnership has only domestic partners, the schedules might be necessary if the partnership made certain deductible payments to foreign related parties of its partners.

Rereading the entire instructions in that light led to other unpleasant revelations, Zollars said, principally, the need in many cases to know whether each partner had any creditable foreign taxes.

"Just the act of getting that information from every partner would prove troublesome where the practitioner did not prepare the partners' returns," Zollars said.

The IRS issued draft versions of the schedules in July 2020. They are lengthy, with the final version of the partnership K-2 extending 19 pages and K-3 at 20 pages (both released in June 2021), and combined instructions covering 34 pages.

One surprise for many practitioners, besides the new schedules' complexity and length, has been the treatment of partners whose foreign or domestic status may be unclear (see Samtoy, "Complying With New Schedules K-2 and K-3," Tax Insider, Feb. 11, 2022). Although the latest IRS statement would seem to assure them that, without foreign partners, they will be excused from filing Schedules K-2 and K-3 this year, the difficulty of documenting partners' or shareholders' domestic status could remain.

"The schedules also require an in-depth understanding of technical rules that many tax professionals are not familiar with," said John Samtoy, CPA, a partner with HCVT in Irvine, Calif., and author of the Tax Insider article.

For example, Samtoy said, a practitioner preparing returns for rental real estate partnerships likely has never considered whether the partnership's qualified nonrecourse financing interest should be allocated at the partnership level or apportioned at the partner level.

"But they are now being asked to determine that on Schedule K-2 and Schedule K-3," he said.

Notice 2021-39 provided that, for tax year 2021, filers would not be subject to certain penalties if they could demonstrate a good-faith effort to comply by changing their systems, processes, and procedures for collecting and processing the relevant information, including obtaining information from partners, shareholders, or a controlled foreign partnership.

"But the assumption that everyone needed this foreign information was, for partnerships, not optional — so just not filing it would not be acting in good faith to attempt to comply," Zollars observed.

Meanwhile, tax software producers have struggled to implement a PDF attachment filing option for the schedules — which for now is the only available method. The IRS announced in December it would be ready to accept this data via the modernized e-File/extensible markup language e-filing protocol by March 20, 2022, for partnerships; in mid-June for S corporations; and not until January 2023 for filers of Form 8865 (see FAQ No. 7, on the IRS FAQ webpage).

"So when these practitioners checked their tax software for e-file status, in many cases, they got those March and June dates, causing a panic that virtually all passthroughs would need to go on extension," Zollars said.

Even so, obtaining a filing extension may be the best course for Schedules K-2/K-3 filers, while the Service continues to assess the situation, Samtoy said.

"I recommend talking to clients to make sure that they are aware of the requirements and the guidance that has been issued thus far," he said. "I would also consider filing extensions so that clients and preparers have time to consider any exceptions or relief that the IRS may announce."

The AICPA continues to advocate for better IRS services; visit the webpage describing AICPA advocacy efforts to learn more.

— To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.

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