New International Reporting Requirements: Schedule K-2 and K-3
By Francesco Quaranta, CPA, Tax Manager, Alternative Investment Group
Don’t be surprised when you and your investors receive a packet of more than 20 pages attached to your 2021 Schedule K-1. Beginning with the 2021 tax year, a pass-through entity treated as a partnership that has any items of international tax relevance or any foreign partners is required to also file Schedule K-2 with Form 1065 and Schedule K-3 with the Schedule K-1’s. S-Corporations filing Form 1120-S and U.S. persons filing Form 8865 will have similar Schedule K-2 and K-3 filing requirements.
Although your pass-through entity might not have any direct foreign partners or foreign source income, reporting could still be necessary due to other direct and indirect partners. The IRS highlighted this in its latest update to the instructions released on January 18, 2022: “A partnership with no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3. For example, if the partner claims a credit for foreign taxes paid by the partner, the partner may need certain information from the partnership to complete Form 1116.”
Purpose of Schedule K-2 and K-3
Previously, items related to international taxes were either reported on Schedule K-1, line 16, or were provided to partners as a footnote to their Schedule K-1. The purpose of these new schedules is to help partnerships provide their partners with the necessary information for their own U.S. income tax returns in a more standardized format. This standardized process will aid the IRS in matching items reported by the pass-through entity to the ultimate taxpayer.
Not every part of Schedules K-2 and K-3 is required to be completed. Partnerships only need to complete any relevant parts as applicable to the taxpayer.
The following parts of Schedules K-2 and K-3 represent what will now be standardized:
|Part I:||Partnership’s Other Current Year International Information|
|Part II:||Foreign Tax Credit Limitation|
|Part III:||Other Information for Preparation of Form 1116 or 1118|
|Part IV:||Information on Partner’s Section 250 Deduction With Respect to Foreign-Derived Intangible Income (FDII)|
|Part V:||Distributions from Foreign Corporations to Partnership|
|Part VI:||Information on Partner’s Section 951(a)(1) and Section 951A Inclusions|
|Part VII:||Information to Complete Form 8621|
|Part VIII:||Partnership’s Interest in Foreign Corporation Income (Section 960)|
|Part IX:||Partners’ Information for Base Erosion and Anti-Abuse Tax (Section 59A)|
|Part X:||Foreign Partners’ Character and Source of Income and Deductions|
|Part XI:||Section 871(m) Covered Partnerships|
|Part XII:||Reserved for Future Use|
|Part XIII:||Foreign Partner’s Distributive Share of Deemed Sale Items on Transfer of Partnership Interest (Schedule K-3 only)|
Although a lot of the international tax information is now standardized on Schedules K-2 and K-3, it still might be necessary to attach whitepaper details to the Schedule K-1s. Some of this additional necessary information relates to Forms 926 and Form 8865.
First-Year Penalty Relief
The IRS recognizes that the transition to reporting all relevant information on these schedules may create challenges for taxpayers. As outlined under Notice 2021-39, for the 2021 tax year the IRS will provide some relief to taxpayers with respect to penalties associated with Schedules K-2 and K-3. During the transition period, a taxpayer may be eligible for penalty relief if they can show that a good faith effort was made to comply with the new requirements.
The Tax Cuts and Jobs Act of 2017 brought about many changes to international tax filing requirements, as the demand for additional transparency and clarification on IRS tax forms is constantly increasing. Since the IRS is still releasing guidance and changes for Schedules K-2 and K-3, it is important to be mindful and stay up to date. Should you need assistance interpreting these changes in tax law and understanding the new filing forms, please contact your Marcum professional.