Consternation and chaos are two of the words used to describe some of the reactions to IRS updates related to Schedules K-2 and K-3.
On this collaboration episode with the Tax Section Odyssey podcast, CPAs Tim Chan of KPMG and David Sites of Grant Thornton talk about the particulars with April Walker, CPA, CGMA, lead manager–Tax Practice & Ethics for AICPA & CIMA, together as the Association of International Certified Professional Accountants.
What you'll learn from this episode:
- Who needs to file Schedules K-2 and K-3.
- Further explanation of the domestic filing exception.
- How to report foreign-source income.
- Risks and penalties associated with not completing or filing required schedules.
Play the episode below or read the edited transcript:
— To comment on this episode or to suggest an idea for another episode, contact Neil Amato at Neil.Amato@aicpa-cima.com.
April Walker: Hello, everyone, and welcome to this collaboration between the Journal of Accountancy podcast and the AICPA's Tax Section Odyssey podcast. I'm April Walker, host of the Tax Section Odyssey podcast, where we offer thought leadership on all things tax facing the profession.
Today, we're going to be talking about what's new for the 2022 filing year for Schedules K-2 and K-3, with two experts in this area, David Sites and Tim Chan. David and Tim were with me on a podcast that we recorded back in late 2021. David is a managing partner of international tax services at Grant Thornton, and Tim is a managing director at KPMG in their national tax office.
Just wanted to give a quick background here on the schedules. So coming into the 2021 tax filing season, there were still a lot of questions about Schedules K-2 and K-3. These schedules were meant to streamline international tax reporting for flow-through entities.
So in early 2022, about a year ago, as we're recording, the IRS released final instructions for the schedules, and some of the wording and requirements took a lot of practitioners by surprise. Along with this, it was announced that the E-file system was not going to be ready to accept schedules as part of an E-file return, and let's just say chaos ensued.
So mid-February, the IRS provided some additional exceptions for filing those schedules in 2021. Fast-forward to now, getting ready for the 2022 filing season. On Oct. 25, to be specific, of 2022, the IRS issued draft instructions for the 1065 and shortly thereafter, for the 1120-S schedules. They offered a new exception called the domestic filing exception. So some of these requirements for this exception seem like a difficult ask. Thankfully, in the second draft of the instructions, the IRS listened and issued another set of draft instructions. Those were issued on Dec. 2, and subsequently, those have been finalized, Dec. 23.
We're going to be digging into this exception today and talking about other things that you need to know for filing these schedules. So welcome, David and Tim. Before we talk about why you might qualify not to file, let's talk about who needs to file. I've seen some data from 2017 filings that show less than 5% of businesses have international transactions on Line 16, leading to the spoiler alert, I guess, incorrect conclusion that Schedules K-2, K-3 are only applicable to a small number of businesses. David, could you talk about why you think these numbers are misleading and why we need to continue to have all practitioners of all size firms be paying attention to these schedules?
David Sites: Thanks, April. I appreciate it. It's good to be here. That data came out of the IRS when this project started, and that they'd also said that the 5% of businesses that had international transactions on Line 16, also where the partnerships that accounted for more than 50% of all the income reported on partnership returns. So obviously, it was the very largest partnerships that were reporting information on Line 16.
I think it's pretty likely that in pre-TCGA years, that partnerships and other flow-through entities had probably been inadvertently not providing all the relevant data to their partners. I think there was a lot of disparate reporting, a lot of white papers, and the IRS to their credit, cited that as one of the reasons for standardizing and modernizing the mechanism to report information to partners by inventing the K-2 and the K-3.
Tim Chan: The instructions say, does the partnership have items of international relevance? To the lay person, that doesn't necessarily mean that the partnership has to have foreign activity. In the instructions, they give some examples of that. For instance, like a domestic partnership that has just the business in the US, they may have items on that partnership return that may impact the foreign tax that a partner is taking. Even though the foreign tax is not directly accrued or paid from the partnership itself, it may impact foreign taxes that the partner has directly.
Walker: Even practitioners who really know their clients' business, I heard a lot of people saying, "This is not applicable to me or my clients." We just want to continue to say, maybe you can meet an exception for not filing. It's probably applicable to way more than people are thinking. Could you provide me a high-level description of the domestic filing exception that was providing in the new instructions? Let's walk through that.
Sites: The headline of the instructions was the domestic filing exception. Unfortunately, I think, again, there's a little bit of maybe misconstrued information here. The domestic filing exception is available but narrow. So what it does is it's really an offshoot of the previously issued FAQ 15, but it's a two-pronged test. If you meet both prongs of the test, then you meet the domestic filing exception and you don't have to complete and file the K-3 or the K-2 and you don't have to provide K-3s to the partners.
The two prongs are, first, the partner-based one, and then second, a foreign activity-based one. So the first one requires that all the direct partners in the pass-through entity must be US citizen individuals, resident aliens, and then some certain estates and trusts qualify. So it's important here what's not on that list. You can't have a partnership partner, you can't have a corporation partner, you can't have an S corporation partner. You have to have individual partners up there, which obviously, is very limiting for a lot of tier partnerships and business structures.
The second test is that the partnership itself must have either no foreign activity or limited foreign activity. Those two main prongs make up the domestic filing exception. There's some notification requirements, which we'll talk about later, but they've been relaxed. You do have to meet the notification requirements technically to qualify.
Walker: Let's talk about what is defined in this exception as no or limited foreign activity. What are things for our listeners to focus on here?
Chan: Foreign activity includes having foreign income taxes paid or accrued, having foreign source income or losses. It also includes interests held in any foreign entities such as a foreign partnership, a foreign disregarded entity, or foreign branch. So it's a very broad definition of what it means to have no foreign activity.
Now, there is what I call a de minimis exception for certain foreign activity. But it's based off of the exception to claiming a foreign tax credit without having to file the Form 1116. Under that test, it's very stringent. All of the foreign source gross income must be passive. Any related foreign income taxes can't exceed $300, and all of that foreign source income must be reported on a payee statement such as a Form 1099. So it's a very difficult test to meet.
Sites: I want to stress here: the limited foreign activity test where you have only passive income and not more than $300 in taxes. Remember, that's an exception. So any ownership, any foreign source income, any of the other things that Tim talked about, you're in. So you have to have none of that, and then only this passive type of income.
It's really important that people remember, I hear a lot of people talk about, I looked at this and the only thing I've got on this brokerage statement or some foreign taxes and they're less than 250 bucks. But the other parts of their partnership have a significant foreign source income or something like that. So I don't want people to get too narrowly focused on this $300 of passive income. Again, the big story here is that you have to have none of that other stuff.
Walker: That's a great point. Let's say, though, you do meet it or you have businesses that you're filing that do meet it and they have $300 of foreign tax. We've had this discussion. What is your recommendation on how to report that to your partners or shareholders?
Chan: If you have foreign source passive income and the partnership has under the $300 of creditable foreign taxes, even though they're not required to file a K-2, K-3, they still need to pass that information onto their partners. I think similar to last year, if you didn't have to file a K-3, I would think that the partnership would report that information using white paper detail because the partner, for example, if they had foreign taxes associated with the country, presumably they still need to report the country details so that they can report it on the Form 1116.
Walker: Sounds great. OK, so just walking through the criteria now, the criteria also that David mentioned is that all direct partners have to be U.S. citizens or resident aliens. Is there anything specific that you want to note here on this part of the exception?
Sites: Yeah. I do want to note one thing which I find a little bit curious. Obviously, as I mentioned, you can't have any business entity with your partner. If you have a partnership that's a partner in a partnership, that partnership is going to automatically disqualify you from meeting the domestic filing exception. One wonders why, though, if that upper tier partner or partnership only has partners and itself would qualify for the domestic filing exception, why is it that the lower tier partnership needs to provide that upper tier partnership with a scheduled K-3? You could have a situation, for example, where a partnership owns 90% of another partnership and the upper tier partnership has two individual partners and meets the domestic filing exception.
Query why it doesn't appear that the domestic filing exception would extend to the lower tier partnership in that case. You would essentially be filling out a schedule K-3, giving it to a partnership that wouldn't do anything with it because they themselves would qualify for the domestic filing exception. I find that a little bit curious, and I think the AICPA made some comments on that when they submitted some comments on the instructions.
Chan: The other thing that's interesting here is that a lot of people got comfortable around FAQ 15. Under FAQ 15 last year in 2021, it did include a domestic corporation or domestic partnership and so by limiting it just to basically people, like individuals, estates, and trusts that are U.S. people, it's going to really drop off the number of partnerships that are eligible for not completing the K-2, K-3.
Walker: Let's dig in now to the notification pieces of the domestic filing exception. The first one is the partner or shareholder notification. This notification needs to be furnished at the latest when the K-1 is provided, and what it states is no K-2 will be provided unless requested. We've been asked and I think you guys probably have, too, what kind of language should be in this notification? The way I read the instructions, it seems pretty simple. Basically, something like business partnership or business partners or shareholders will not receive Schedule K-3 unless it's requested. Talk a little bit about the notification. Want to make sure that people understand that it changed from the original draft instructions and also just any thoughts on this notification.
Sites: The notification stuff can be confusing. Let's just make sure we pause. As you mentioned, it changed. This was actually a big source of consternation in the first draft instructions, if you will, and there was a really complex and robust notification process that the partnership had to go through. It had to wait to see if partners responded to a notification that was sent to them before the return was filed, and that all got streamlined in the second draft instructions, April, as you mentioned, which I think was extremely welcome.
Basically, it's now just, hey, this needs to be provided with the K-1 or before. It seems very simple. April, I tend to think that the language that's in the instructions is sufficient. The instructions state specifically what you have to notify the partner. My notification requirement that'll be standard on our notifications to the extent we can take advantage of the domestic filing exception will mimic that language.
Walker: Really, the final piece to be able to meet the domestic filing exception is that no Schedule K-3 requests are received on or before the one-month date. The instructions state the latest one-month date for a calendar year filer is Aug. 15, so due Sept. 15, one month prior Aug. 15. Let's talk about how we're handling this from a practical standpoint.
Sites: Notification requirement, like you said, in the instructions states that if you receive a notification before the one-month date then you need to provide Schedule K-3 information. You would not qualify for the domestic filing exception if you receive a notification that you need to provide the K-3s. That one-month date obviously is tied to when you "file your return." It's the one-month date before you file the return. If you file your return on Sept. 15, your one-month date is Aug. 15, which is the latest possible day as you can mention. If you file your return on April 15, your one-month date is presumably March 15. There is a little bit of an unknown if you're a partner and you're attempting to request information.
If you want to get that information on the originally filed return and with the return, you should probably file the notification with the partnership as soon as you can. If you're a partnership, you simply need to know, this is the date we plan to file our partnership return to the extent we don't have a notification by that one month day prior, then we don't have to complete the K-3.
What becomes tricky, and I'll be interested to get Tim's thoughts on whether I missed anything in the one-month date, but what becomes tricky is, let's say you file your return on April 15. You didn't have any notifications on March 15. Then lo and behold, after the time you file your return, you get a notification, "after" the one- month day. You get a notification, say, in June from a partner that says, hey, I need K-3 information. Tim, did I miss anything before we get into maybe that tricky part on notification after the one-month date?
Chan: That's right. I think generally speaking, that for the most part, this is not a tiered structure because as we mentioned earlier, tiered structures are out, so as a partnership that is owned by direct partners, you have a better handle potentially on getting the information on whether or not the partnership meets its domestic filling exception. That being said, if it's a small partnership and you have a handful of partners, obviously, you probably have even more control.
But if you do have the wide number of partners and you are not sure whether or not you meet the domestic filling exception, or meet the domestic filing exception and you're not going to get a notice from one of the partners saying that they need the K-2, K-3 information, you could perhaps as a proactive measure, send out an early notification to the partners asking, hey, do you need the K-2, K-3 information? Because I know in the instructions it says that you can provide the notification through the K-1, but if you want to make sure that no one's going to ask for it after the one-month date, then you may want to proactively send out notifications prior to sending out the K-1s.
Sites: I think that's great insight, which is ironically what the original draft instructions had as the mechanism, where the partnership would in advance notify the partners, hey, you're not going to get a K-3. While they went away from that as a qualification point, I think it's still as a good practice to the extent you're unsure, but I agree with you. I think in most situations, the partnership is going to have visibility as to whether that partner is going to make a request or not.
Chan: Now the helpful thing here is that if you do get a request after the fact that the partnership is only required to provide the K-3 to the partner that requests the information, you at least have a month generally speaking. If the partnership filed the return on March 15, but then on April 1, they receive a request from one of the partners, the instructions say that they have on the later of the date in which the partnership files the 1065 or one month from the date of that request. If you've got the request after it is filed, it would be one month from April 1. That's helpful from that perspective, that you don't have to go back and necessarily file an amended or AAR, administrative adjustment, to correct that return, you just have to provide the information to that one partner.
Walker: Right. There was also the language around then now you're notified that they need it. For the subsequent year, say for 2023, now you have to complete the K-3 for that partner or shareholder, right?
Sites: Correct. That is exactly what the instructions say is that for 2023, you have to complete the K-2 and the K-3 with respect to the notifying partner, which is interesting. It doesn't kick you in and say you have to complete it for every partner. You just have to proactively do it next year for the notifying partner. That is correct.
Walker: We're going to move to another exception for filing Schedule K-2, K-3 and that is the 1116 exception. It also has several parts. If you guys would talk about that, talk about the exception itself and how that actually might be a way for smaller businesses to be able to get out of filing the Schedule K-2, K-3.
Sites: I think it's a really viable alternative for certain businesses that need it. And let's talk about what it is first. The Form 1116 exception states that if all of your partners in your partnership qualifies for the Form 1116 filing exemption. The code provides that to the extent you only have passive income and you have less than a certain amount of dollars in taxes, which is $300 here, $600 for married filing joint, that individual that meets that criteria doesn't have to file a Form 1116 to claim a foreign tax credit. They're not required to go through the 904 process. Essentially, they're exempted from having to apply Section 904.
If you have all partners that qualify for that 1116 exemption, and this is the important part, and those partners notify you, the partnership, regarding their eligibility for the exemption. They have to send you something saying, I qualify for the Form 1116 exemption and they have to send it to you by the one-month date and the one-month date we talked about, is that one-month-before-you-file date.
The latest for that notification would be August for a calendar year partnership. If that is true, then you don't have to complete the Schedule K-3s for the partners and you don't have to complete the Schedule K-2. You can have a situation where you have a partnership that has, say, $1,000 of foreign taxes all on passive income. We know that $1,000 is more than $300. They don't qualify for the domestic filing exception.
But let's say that they've got four partners up top, all of which qualify for the Form 1116 exemption and they notify the partners. If each of those partners qualifies because they were entitled to say, an equal share of $250 in those taxes. That's the only foreign taxes they have and they notify the partnership. Then a partnership doesn't have to file, as I've mentioned.
It's a little bit of a misnomer under the domestic filing exception that more than $300 of taxes on passive income are going to automatically disqualify you. Presumably there are some partnerships out there that have all individual partners that would otherwise qualify for the domestic filing exception, but have nonetheless more than $300 in taxes. There's a great example in the instructions about a husband and wife and the partnership has more than $300 in taxes, so it doesn't qualify for the domestic filing exception, but the husband and wife do qualify for the domestic filing exception. They notify the partnership, and the partnership doesn't have to complete the Schedule K-3.
Walker: Great. Just to reiterate, the partnership has to receive notification from the partners or from the shareholders if we're talking about an S corp. in that case, so this is pushed from the other way. This is not the business pushing this down. This is coming from the shareholders and the partners. Just a little bit of a rethinking about it, but definitely great information I think to share. Thanks, David.
Chan: The notification has to come from the partners as well because partnership may not know what else the partner has, and so the only way that the partner knows with certainty is if they get that notification from the partners.
One thing I also want to point out here is that baked into this requirement that all partners must be eligible for the Form 1116 exemption. While it's not expressly spelled out, they're pretty clear in the instructions when they intend to loop in indirect partners because they'll mention direct or indirect partners. I think here it seems that they're saying that all partners, I think they mean direct partners, must be eligible for the Form 1116 exemption, which implies that if you have any partnerships with partners that are pass-through entities or corporations are not eligible for this exemption.
Walker: Perfect. Final question here. We've talked a lot about some in-depth technical topics here today, but I want to talk about another question that we get, which is, what's the risk and penalties associated with not completing and not providing these Schedule K-2, K-3 if they are required to be filed? Also let us know, does the penalty relief in Notice 2021-39 apply for 2022? Tim, can you talk to us about these issues?
Chan: The relief that was provided and Notice 2021-39 said that essentially you had relief against certain penalties for failure to file K-2, K-3 and those penalties are roughly $200 to $500 and it can be multiplied by the number of partners. There's different penalties for failure to file a K-2 and there's a different penalty for failure to file K-3. That penalty relief was not extended for 2022.
The bigger risk here is the threat of potentially the partnership audit rules because, yeah,there are penalties for the failure to file a K-2, K-3, but if the IRS comes in and also assesses you for the failure to file these items on the K-2, K-3, generally, they may treat these items as non-income items, which means that they can assess a tax against each of these adjustments at the highest Chapter 1 tax rate for that year. It could be up to the 37% for every item that you're missing.
The IRS is growing, they're investing in technology. They are motivated to increase their enforcement and audit activity. Having all this information on the K-2, K-3, it really standardizes and lines up the data and enables them to match that data to the partners' tax returns. I think it remains to be seen whether or not they will go after the partnerships for either the failure to file the K-2, K-3 or failing to file certain parts of the K-2, K-3. I think that that's probably the thing that we have to look forward to going in the next couple of years.
Walker: "Look forward to" is a good way to put that. Thank you so much, David and Tim. This was very insightful for me and I hope for our listeners, too. I want to give you both an opportunity to give some final thoughts to our listeners as you're thinking about these complicated issues. David, I'll let you give some final thoughts if you would like.
Sites: Thanks April, and thanks for having me. Here's my final thoughts. The K-2, K-3 is here to stay. The vast majority of partnerships are going be required to complete it. It's a data exercise. I encourage taxpayers that maybe have struggled with it through the first period or are having difficulty sourcing data to really think about setting up a long-term data collection system that's going to allow them to populate this form because it's going to be an annual process. I think the form is here to stay, like I said, I don't think there's going to be any more exemptions. I think that people will do well where they're invested in the right technology and tools to help them comply with this.
I'm actually very excited. I look forward to a day where we can scan K-3s in and have information add up into your partnerships. I do think it will lead to increased transparency and people will ultimately have the information that they need. I recognize the short-term pain, but I think it's here to stay and it's time for people to come up with a long-term plan to deal with it.
Walker: Yeah. I love that. I love making positive thoughts out of temporary pain. What about you, Tim?
Chan: I agree with that. Everyone was waiting with bated breath to see whether or not the K-2, K-3 was going to rescinded or something like that. It's definitely here to stay. I think this being the second year, it's a time to reflect on what you did in the prior year. Technology is a big part of it, but also just making sure that you understand the technical rules behind the international provisions.
I think what gets lost a lot of times is like people understand or have a better understanding of the partnership rules, but those same people may be trying to apply the international provisions. Sometimes the rules in the partnership space may be similar to some of the international concepts, but the international concepts are different. I think it's a good time to reset and rethink about what you're doing for year two, considering that we're going to have to do this for years to come.
Walker: That's right. Thanks again so much, David and Tim. Again, this is April Walker from the AICPA Tax Section. This community is your go-to source for technical guidance and resources designed especially for CPA tax practitioners like you in mind. This is a podcast from AICPA & CIMA, together as the Association of International Certified Professional Accountants. You can find us wherever you listen to your podcasts and we encourage you to subscribe so you don't miss an episode. You can also find us at aicpa.org/tax to check out our other episodes and get access to the resources we mentioned during the episode. Thank you for listening.