IRS Updates FAQs for New Schedules K-2 and K-3

(Parker Tax Publishing June 2022)

The IRS recently updated the Frequently Asked Questions (FAQs) website which discusses the new 2021 Schedules K-2 and K-3 on its website. Among things, additional information on the timelines for electronically filing these schedules is provided and the FAQs clarify the reporting of information on certain lines of the Schedules K-2 and K-3. Form K-2 and K-3 FAQs.

Background

Form 1065, U.S. Return of Partnership Income, Form 1120S, U.S. Income Tax Return for an S Corporation, and Form 8865, Information Return of U.S. Persons with Respect to Certain Foreign Partnerships, include Schedules K-2, Partners' Distributive Share Items - International, and K-3, Partner's Share of Income, Deductions, Credits, etc. - International. These schedules are new for the 2021 tax year. In a recent news release (IR-2022-38), however, the IRS announced that eligible domestic partnerships and S corporation are exempt from filing the new schedules for tax year 2021. To be eligible for the exemption, the following four criteria must be met:

(1) In tax year 2021, the direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts.

(2) 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 (i.e., Reg. Sec. 1.861-9(g)(3)).

(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, Code Sec. 250, Code Sec. 864(c)(8), Code Sec. 721(c) partnerships, and Code Sec. 7874) (Line 17d for Form 1120-S).

(4) The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021.

Practice Tip: If a partnership or S corporation qualifies for this exception, the domestic partnership or S corporation does not need to file Schedules K-2 and K-3 with the IRS or with its partners or shareholders. However, if the partnership or S corporation is subsequently notified by a partner or shareholder that all or part of the information contained on Schedule K-3 is needed to complete their tax return, then the partnership or S corporation must provide the information to the partner or shareholder. If a partner or shareholder notifies the partnership or S corporation before the partnership or S corporation files its return, the conditions for the exception are not met and the partnership or S corporation must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS.

The new schedules replace, supplement, and clarify the reporting of certain amounts formerly reported on Form 1065, Schedule K, Partners' Distributive Share Items, line 16, Foreign Transactions, and Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc., Part III, Partner's Share of Current Year Income, Deductions, Credits, and Other Items, line 16, Foreign Transactions. Schedules K-2 and K-3 also replace, supplement, and clarify reporting of certain amounts formerly reported on Form 1065, Schedule K, line 20c, Other items and amounts, and Schedule K-1 (Form 1065), Part III, line 20, Other information.

According to the IRS, the benefits to taxpayers of Schedules K-2 and K-3 are twofold: (1) having consistent and standardized forms and instructions will help partners and partnerships and shareholders and S corporations to comply with the various complex international tax rules in an efficient manner; and (2) while partnerships and S corporations will initially have transition costs, ultimately they will benefit from increased transparency of information, and reduced uncertainty about what to report and how to report it.

Observation: In Notice 2021-39, the IRS provides transition relief for tax years that begin in 2021 with respect to new Schedules K-2 and K-3. 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).

Frequently Asked Questions

The IRS website has a page devoted to Frequently Asked Questions about Schedules K-2 and K-3. Recently, the IRS added several new Q&As.

Electronic Filing: As to whether the schedules can be filed electronically, the IRS said yes. However, Modernized e-File (MeF)/Extensible Markup Language (XML) electronic filing capability for the schedules K-2 and K-3 for tax year 2021 will not be available as of the beginning of the 2022 filing season. The timeline for the MeF/XML filing capability is provided below. The MeF/XML filing capability for the Form 1065 was available starting on March 20, 2022. If a taxpayer electronically files a return before the time frames, the taxpayer must submit the schedules as separate PDF files attached to the return. Taxpayers will also be able to file their Schedules K-2 and K-3 via PDF attachments for the entire 2022 filing season.

Form 1065, Schedules K-2 and K-3 ... .. March 20, 2022

Form 1120-S, Schedules K-2 and K-3 ... .. July 24, 2022

Form 8865, Schedules K-2 and K-3 ... .. January 2023

Filers of Forms 5471, 8865, and/or 8858: If the filer meets one of the exceptions to filing Forms 5471, 8865, and/or 8858, the filer is not required to complete and attach those forms. However, the filer must still attach to the Forms 1065, 1120-S, and the tax return of the U.S. person filing Form 8865, any required statements to qualify for the exception to filing the Forms 5471, 8865, and/or 8858. Further, in the case of the Form 5471 multiple filer exception, the partnership or S corporation must provide on the Schedule K-3 to its partners or shareholders any information that the partnership or S corporation receives from the person required to file the Form 5471 and that is requested by the Instructions to the Schedules K-2 and K-3, such as Schedule Q (Form 5471) information, if applicable.

Dormant Foreign Corporation: Part VIII (Form 1065) and Part VII (Form 1120-S) are not required to be completed with respect to dormant foreign corporations. This clarification, the IRS said, will be added to the tax year 2022 instructions. However, filers may follow this clarification for tax year 2021.

Reporting Accrued Original Issue Discount (OID): A partnership generally reports OID on Schedules K and K-1 (Form 1065) in the tax year the OID accrues. However, the instructions to Part X of Schedules K-2 and K-3 (Form 1065) require the partnership to report OID only when it is taxable to foreign partners (i.e., when there is a payment or gain on the OID instrument). To reconcile Schedules K-2 and K-3 reporting of OID with Schedules K and K-1 reporting of OID and to provide foreign partners with the information necessary to complete their returns, the IRS recommends the following approach for reporting OID on Part X.

The amount of accrued OID reported on Schedules K (Form 1065) which is not taxable to foreign partners should be reported as interest income in column (f) (U.S. source (other)) of Part X, Schedule K-2. The IRS recommends that the partnership attach a statement to Form 1065 with respect to Part X clarifying that these amounts are not taxable to foreign partners and need not be reported on the foreign partner's tax return. The partnership should take a similar approach for reporting distributive share amounts to a foreign partner on Schedule K-3.

Observation: According to the IRS, this approach is solely a recommendation for tax year 2021, and the IRS recognizes that partnerships may have taken other approaches. The IRS said it would appreciate comments on this approach and whether there are other approaches to reporting OID on Part X of Schedules K-2 and K-3 and will take these comments into account for the tax year 2022 Instructions to the Schedules K-2 and K-3.

Example: In addition to other income and expense items, a partnership accrues $100 OID in Year 1 reported on Schedule K (Form 1065). On Part X of Schedule K-2 for Year 1, the partnership should report this amount as interest in column (f) (such amount is also included in column (a) for the total). In Year 2, the partnership receives a payment with respect to the same instrument that results in $50 of gross income taxable on a gross basis to its foreign partners. On its Part X of Schedule K-2 for Year 2, the partnership should report $50 as interest in column (e) and ($50) as a reconciliation adjustment in column (f). The partnership should take the same approach for reporting distributive share amounts to a foreign partner on Schedule K-3 in both Years 1 and 2.

For a discussion of partnership and S corporation tax reporting, see Parker Tax ¶28,550 and ¶36,500, respectively.

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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