IRS Provides 2021 Penalty Relief for New Schedules K-2 and K-3

(Parker Tax Publishing July 2021)

The IRS announced that it is providing transition relief for tax years that begin in 2021 with respect to new Schedules K-2 and K-3 required for Forms 1065, U.S. Return of Partnership Income, 1120-S, U.S. Income Tax Return for an S Corporation, and 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. During this transition period, a partnership required to file Form 1065, an S corporation required to file Form 1120-S, or a U.S. partner required to file Form 8865 will not be subject to penalties for any incorrect or incomplete reporting on the Schedules K-2 and K-3 if the filer establishes to the satisfaction of the IRS that it made a good faith effort to comply with the Schedules K-2 and K-3 filing requirements (and the Schedule K-3 furnishing requirements). Notice 2021-39.

Background

Under Code Sec. 6031, a partnership generally must (1) file a return for each year stating the items of its gross income and deductions and any other information as prescribed by forms and instructions, and (2) furnish to its partners statements containing each partner's distributive share of the partnership's items of income, gain, loss, deduction or credit, and any additional information as prescribed by forms or instructions. Code Sec. 6037 provides similar requirements with respect to an S corporation.

Code Sec. 6038(a)(1), Code Sec. 6038(a)(5), and Reg. Sec. 1.6038-3 generally require a U.S. person that controls a foreign partnership or holds at least a 10-percent interest in a foreign partnership that is controlled by U.S. persons holding at least 10-percent interests (a U.S. partner) to furnish information relating to the partnership (a controlled foreign partnership or CFP), including information relating to the U.S. partner's ownership interests in the partnership and allocations to the partner of partnership items. A U.S. partner that controls a CFP may also need to provide information relating to another U.S. partner's ownership interest in the partnership and allocations to that partner of partnership items. Under Code Secs. 6031, 6037, and 6038 and the accompanying regulations, the IRS has, in forms and instructions, long required that any partnership, S corporation, or U.S. partner in a CFP report information of international tax relevance.

Form 1065, Schedules K-2, Partners' Distributive Share Items - International, and K-3, Partner's Share of Income, Deductions, Credits, etc. - International, are new for tax years beginning in 2021. These schedules replace, supplement, and clarify the reporting of certain amounts formerly reported elsewhere on Form 1065, Schedule K, Partners' Distributive Share Items, and Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc. The new standardized format assists partnerships in providing partners with the information necessary to complete their returns with respect to the international tax aspects of the Code and allows the IRS to more efficiently verify tax compliance. For the same reasons, for tax years beginning in 2021, Form 1120-S includes new Schedules K-2, Shareholders' Pro Rata Share Items - International, and K-3, Shareholder's Share of Income, Deductions, Credits, etc. - International, and Form 8865 includes new Schedules K-2, Partners' Distributive Share Items - International, and K-3, Partner's Share of Income, Deductions, Credits, etc. - International.

On July 14, 2020, the IRS released for public comment drafts of the Form 1065, Schedules K-2 and K-3 and the associated instructions. At that time, the IRS also requested comments on the Forms 1120-S and 8865 with respect to which the IRS planned to issue similar Schedules K-2 and K-3. After considering the comments received, on June 3 and 4, 2021, the IRS released the final versions of new Schedules K-2 and K-3 for the Forms 1065, 1120-S and 8865 applicable for tax years beginning in 2021.

Penalty Relief

In Notice 2021-39, the IRS provided transition relief for tax years that begin in 2021 (processing year 2022) with respect to Schedules K-2 and K-3 to Forms 1065, 1120-S, and 8865. During this transition period, a partnership required to file Form 1065, an S corporation required to file Form 1120-S, or a U.S. partner required to file Form 8865 (a "Schedule K-2/K-3 filer") will not be subject to penalties under Code Secs. 6698, 6699, 6721, 6722, and 6038 for any incorrect or incomplete reporting on the Schedules K-2 and K-3 if the filer establishes to the satisfaction of the IRS that it made a good faith effort to comply with the Schedules K-2 and K-3 filing requirements (and the Schedule K-3 furnishing requirements) per the instructions. A Schedule K-2/K-3 filer that does not establish that it made a good faith effort to comply with the new requirements will not be eligible for penalty relief under Notice 2021-39.

For purposes of determining whether a Schedule K-2/K-3 filer makes a good faith effort to complete Schedules K-2 and K-3, the IRS will take into account the extent to which a Schedule K-2/K-3 filer has made changes to its systems, processes, and procedures for collecting and processing information relevant to filing the Schedules K-2 and K-3 and the extent to which a Schedule K-2/K-3 filer has obtained information from partners, shareholders, or the CFP, or applied reasonable assumptions when information is not obtained. The IRS will also take into account the steps taken by the Schedule K-2/K-3 filer to modify the partnership or S corporation agreement or governing instrument to facilitate the sharing of information with partners and shareholders that is relevant to determining whether and how to file Schedules K-2 and K-3.

According to the IRS, in several instances, certain information about partners, shareholders, or the CFP is relevant for determining the applicability of a part of Schedules K-2 and K-3. For example, if a partnership has a direct or indirect partner that is a nonresident alien individual or a foreign corporation, the partnership must complete Form 1065, Part X of Schedules K-2 and K-3. Information about the partners, shareholders, or the CFP is also relevant for determining how to report some amounts. For example, for tax years beginning in 2021, the instructions for Form 1065, Part IX of Schedule K-2 and K-3 state that a partnership is expected to collaborate with its partners to identify the foreign related parties of each partner.

The IRS said that it is aware that a Schedule K-2/K-3 filer may not currently have systems or procedures in place to obtain information about its partners, shareholders, or the CFP to determine whether it must file a part of Schedules K-2 and K-3 or how to complete a part that must be filed. In general, in the tax year 2021 instructions, unless the Schedule K-2/K-3 filer has knowledge to the contrary, it must file or complete certain parts assuming that the information would be relevant to the partner or shareholder. Under Notice 2021-39, during the transition period, a Schedule K-2/K-3 filer will not be subject to penalties for any incorrect or incomplete reporting on Schedules K-2 or K-3 if it establishes to the satisfaction of the IRS that it made a good faith effort to determine whether it must file a part and how to complete a part that it files.

With respect to information about partners, shareholders, or the CFP that is relevant to determine whether to file and how to complete a part, the IRS said that it will assess the effort the Schedule K-2/K-3 filer made to obtain this information and the reasonableness of any assumptions, taking into account the relationship between the Schedule K-2/K-3 filer and its partners, shareholders or the CFP. For example, the appropriate level of diligence and/or the reasonableness of an assumption may differ with respect to a partner that manages or controls the partnership, or a partnership with a partner with a significant interest in the partnership, such as a partner with a 10-percent interest, as compared to partners holding small interests for which there may not be the same ease of access to information. Nevertheless, a Schedule K-2/K-3 filer may have made a good faith effort despite being unsuccessful in obtaining information from its partners, shareholders, or the CFP.

For a discussion of Forms 1065 and 8865 filing requirements, see Parker Tax ¶28,550. For a discussion of Form 1120-S filing requirements, see Parker Tax ¶36,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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