Grappling with Schedules K-2 and K-3

K-2 — isn’t that a mountain?

K2 is, but to tax professionals and with the hyphen, it’s Partners’ Distributive Share Items — International (and, for S corporations, a similar form), the new schedule filed with the returns of passthrough entities with “items of international tax relevance” and partners in foreign partnerships. Along with its “twin peak” of Schedule K-3, Partner’s [or Shareholder’s] Share of Income, Deductions, Credits, etc. — International, these formidable forms have been much discussed by CPAs and other tax practitioners lately. Here to help us better understand them is John Samtoy, CPA, who has written about Schedules K-2 and K-3 for the Tax Insider newsletter recently.

What you’ll learn from this episode:

• Some of the obvious and not-so-obvious items of international tax relevance.
• Which entities do not have to file Schedules K-2 and K-3.
• When domestic passthrough entities might need to file the schedules despite having no foreign partners, interests, or activities.
• Tips on supporting and documenting a decision not to file the schedules.

Play the episode below or read the edited transcript:

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

Transcript:

Paul Bonner: Hello, this is Paul Bonner. I write tax news for the Journal of Accountancy and The Tax Adviser. I’m thrilled to have as our guest for this podcast John Samtoy, CPA, who specializes in international tax at HCVT LLP in Irvine, Calif. He’s the author of “Complying With New Schedules K-2 and K-3,” in the Feb. 11 Tax Insider newsletter, which is also available on the website of The Tax Adviser, and I’ll provide that link in the written introduction to this podcast. John will talk about these schedules for passthrough entities and U.S. persons who are partners in foreign partnerships, and how tax professionals can help clients with them — right after this word from our sponsor.

Bonner: Welcome, John, and thank you for talking with us about this.

John Samtoy: Thank you for having me; I’m excited to be here.

Bonner: Great. What we might start with is the touchstone, as I understand it, of what K-2 and K-3 are supposed to capture, and that is “items of international tax relevance,” which seems to me a kind of vague phrase, really. But the IRS has provided some guidance on what that means, and you’ve noted some of them in your article. What are some of those, and what are, perhaps, some of those that affected taxpayers might not be thinking about?

Samtoy: Yes, I think it’s almost something that’s a little intentionally vague because it’s very broad. When people first heard “items of international tax relevance,” I think they were picturing partnerships with foreign subsidiaries, foreign-sourced income, maybe receiving dividends from overseas. But it includes almost anything that could affect the international provisions of the Internal Revenue Code. So a purely domestic partnership with income and deductions that need to be sourced has items of international tax relevance because those items can affect the ability of the partnership’s partners to claim foreign tax credits.

So, when we’re talking about those items, we’re looking at foreign tax credits; of course, interests in foreign entities; distributions from foreign corporations; interests in passive foreign investment companies, or PFICs. It’s almost like you have to look at the Schedule K-2 and go through each part of the form to see all the different items and sections that the IRS has there and everything that they view as having international tax relevance.

Bonner: Yeah. There is a stated reason for this, although people find it somewhat burdensome or confusing, I guess. The reason, as I understand it, is to provide the partners and shareholders of S corporations with information that they need for their own returns. And a lot of the attention has been focused on the administrative burden on the entities to file these schedules, but I think in your article you also make a good point that this is helpful to the partners and shareholders and to the IRS in administering the law. How do we think of this in a way that balances out these competing interests?

Samtoy: Yeah, it’s tough, because the two sides are pulling in different directions, to an extent. I think the IRS in their FAQs, the frequently asked questions, that they released on Feb. 16 or Feb. 17 tried to do a better job of emphasizing why the schedules are being released and why they’re asking for the information. It’s something where partners in partnerships, or shareholders in S corporations, that have international activity, that have assets or income overseas or interests in foreign corporations, are receiving statements with information on white-paper detail that’s incomplete and inconsistent.

You look through, and maybe they have interests in passive foreign investment companies, and it’s not clear whether the partnership is reporting that partner’s share of the information or the information for the partnership as a whole; some information is left off because there’s no standardized format for reporting. So it’s something that’s tough for partners to deal with.

And then a lot of the [Schedule] K-1s, [Partner’s Share of Income, Deductions, Credits, etc.], if they have foreign activities, are issued close to that Sept. 15 filing deadline, where they’re getting a lot of that information, and then partners need to turn around their returns by Oct. 15, so the timelines, the windows, are really tight. So the compliance there is something that is difficult for taxpayers that receive these types of K-1s where there’s a lot of foreign activity.

The other side of it, the compliance burden, is a big deal as well, and, certainly, large private-equity funds, hedge funds, they have a large cost burden, but they’re also in a good place to deal with it because they’re set up where they have tax advisers that are used to dealing with these international tax issues that can help them with these schedules. They may have been preparing for it for months before the start of the new year here.

I think where we’re really seeing an outsized burden is small, closely held partnerships with solely domestic assets. They’re not used to sourcing income and deductions under the [Sec.] 861 rules and those regulations. It’s just not stuff that they’re used to dealing with, and now they’re being asked to complete these fairly complex schedules because a partner may need to claim a foreign tax credit, or they may have a corporate partner that needs information for FDII [foreign-derived intangible income], even though it doesn’t really have anything to do with their partnership directly.

And I think that’s tough, and there’s a compliance burden being placed on them — certainly, time and professional fees. And even those professionals, here in the tax industry — we’re seeing a lot of professionals who aren’t used to dealing with those rules, either. It’s tough, it’s a burden, and it’s something that is coming out — I don’t want to say rushed — but the XMLs aren’t ready to efile; the IRS has recognized that as well. People are seeing it for the first time; the draft was released only a few months ago. So it’s something that people aren’t completely prepared for.

Bonner: Those XMLs, we should perhaps say, mean that you can’t efile these returns yet, and it may be even later for some of them.

Samtoy: That’s exactly right.

Bonner: You mentioned the Feb. 16 FAQs, and FAQ 11 has a long list of those situations, doesn’t it, in which an entity has no direct partners that are foreign individuals, estates, trusts, partnerships, or corporations — and so those are excused from having to file these schedules — but there’s a rather long list in FAQ 11 of situations where an entity, even though it has no foreign partners of those sorts still has to file the return. That’s kind of a mindbender for me. I don’t know how you parse it in your own practice.

Samtoy: Yeah, it’s tough because it’s almost like an exception to the exception. Originally, again, when these schedules came out, people were thinking, “Oh, only partnerships or S corporations with offshore holdings need to file,” and then there was some clarification that, well, actually, almost every passthrough entity may need to file because they have partners that need to claim a foreign tax credit or corporate partners that need information for foreign-derived intangible income or something along those lines. And then they came out with this exception that, well, if you only have domestic shareholders or domestic partners, and there’s no foreign assets and there’s no foreign income, then you don’t have to file, except when all these things apply, including where there’s a partner who may need to file the Form 1116 [Foreign Tax Credit] to claim a foreign tax credit.

Bonner: We should perhaps note that these schedules are 19 and 20 pages long, so they’re rather involved, aren’t they?

Samtoy: Yeah, they definitely are. There’s a lot of detailed information being reported here. The Schedule K-3 — also, there’s a separate one issued to each partner. I’ve seen some early feedback, at least, that not all the tax software is taking the information on Schedule K-2 and importing it to the Schedule K-3 completely correctly, so you have these 19- and 20-page schedules, plus separate K-3s issued to each partner, and the tax software is not always completely up to date.

So there’s a lot of compliance work there. You could just imagine the burden that puts on tax professionals and then also on partnerships themselves that are trying to grapple with this new filing requirement and professional time and everything associated with that.

Bonner: As you may know, the AICPA has advocated that this requirement be postponed until next year. Your article seems to suggest that some of the benefits — I don’t know; how do you feel about a postponement?

Samtoy: I think there’s a lot of confusion now. I think maybe a limited postponement could make sense, where partnerships don’t have any foreign assets or foreign income. Then, in all cases, they could say, “We’ll postpone that till next year,” even if there are these partners that have a foreign tax credit or some of the other unique issues that we’re addressing.

For partnerships or S corporations that have foreign income, foreign assets, offshore investments, I think those entities are more prepared to file these schedules, and that’s also where I see a lot of the benefit from having these schedules come, is those partners or S corporation shareholders really need that detailed information to file their own returns. And they really get the benefits from it. I think there’s an outsized compliance burden, compared to the benefit, where there’s a partnership with no foreign income or foreign assets, and they’re still being asked to complete these schedules.

Bonner: So, the one-person-shop preparer who isn’t quite sure whether one of his clients really needs these, what should that person do?

Samtoy: Again, it’s tough. There’s almost a presumption, I think, that these schedules may be required. There’s an update to the form instructions, separate from the frequently asked questions that the IRS released, that I don’t believe has been incorporated into the downloadable PDF version of the instructions. But those updates have some examples and different notes that are supposed to be added to the published instructions, and one of them goes through an example of when these schedules aren’t required. And that example illustrates the situation where the partnership has actual knowledge that none of its partners need to file Form 1116 to claim a foreign tax credit.

So it seems like it’s almost a situation where, if you don’t know that you need to file, then you do need to file, which, again, there’s a fairly large compliance burden that’s being placed on passthrough entities there.

There is some penalty relief that the IRS announced, where partnerships or passthrough entities make a good-faith effort to comply with these new filing requirements. So that could be something that provides relief where a preparer attempted to determine whether this was required, they came to the conclusion that it wasn’t, and they documented their reasons why they didn’t think it was required, and then it’s later determined it was required. Then maybe that penalty relief could come into play to excuse any penalties due to the missed filing.

Bonner: Well, there’s no due-diligence checklist, but you could make your own, couldn’t you?

Samtoy: That’s right, and with anything like that, documentation is key. You want to document the steps you went through, the different things you looked at, and how you came to your conclusion. And you want to do that while you’re doing it, whether that’s in an email you send to yourself and the clients, or whether that’s file notes. It’s not something you want to have to go back and re-create later to try to figure out what you did a few months ago.

Bonner: So this could involve partnerships canvassing their partners specifically for this information, couldn’t it?

Samtoy: That’s right, yes, I think there will be a lot of that. If you decide that you may not have to file these forms, then you do need to verify some of that information with your partners to make sure.

Bonner: Yeah. So just in closing here, I’m just wondering if you have any reflections from your firm’s own experience with these schedules. We’re in the middle of tax season — and thank you again for taking time out of it to talk with us.

Samtoy: Yeah, it’s been something that we’ve spent a lot of time looking at for all of our clients. I’m focused on cross-border tax, international tax, so it’s something that I was looking at ahead of time. I’m pretty familiar with these rules. But something that’s reflective of the industry at large. A lot of our partners within the firm that maybe deal with strictly domestic partnerships, like a closely held real estate partnership or manufacturing partnership that doesn’t have any foreign activity, it’s been confusing, just the timing of when the forms came out, when the rules came out.

Initially, it looked like every single passthrough entity would have to file these forms. And then guidance has kind of trickled out in the middle of filing season, once work was already underway, saying, “Well, no, actually, maybe you don’t have to file these forms if you meet these exceptions.”

And then, like we mentioned with FAQ 11, there’s kind of an exception to that exception, so it’s been tough, the way the information has come out, I think. But it’s something that the industry at large is grappling with, and I know industry groups like the AICPA are probably trying to address that as well.

Bonner: Indeed. Well, thank you so much, John, for joining us and talking about this issue that has garnered so much discussion. I think I’ve seen practitioners talking about it a great deal, and I know they’re interested and eager to hear insights from people who’ve been grappling with it.

Samtoy: Yeah, happy to come on and talk about it, so thanks for having me.

Bonner: OK, thank you.