The Internal Revenue Service (IRS) has introduced a new reporting requirement for the 2021 tax year for any pass-through entities with international activities, including entities with foreign partners. The agency has created two new forms, Schedules K-2 and K-3, to supplement all Schedule K-1 filings. Many of the international items required by Schedules K-2 and K-3 were formerly reported on a partner’s or shareholder’s Schedule K-1 as foreign transactions. However, the introduction of Schedules K-2 and K-3 clarifies and standardizes the reporting of international items required to be reported by the IRS and how they must be documented. While the tax agency has given significant notice that these new requirements are coming, many organizations may still be unsure how to proceed.
These new forms are a landscape shift in reporting standards for international tax-related matters for income, expenses and credits for pass-through entities. In past years, a pass-through tax filer may have addressed its K-1 international disclosure requirements by including the information it deemed was necessary to its partners or shareholders in a K-1 footnote. Oftentimes, this approach could be cumbersome to partners or shareholders—not only due to the non-standardized format of these disclosures, but also from the inconsistent information reported. Schedules K-2 and K-3 seek to address this issue and provide partners and shareholders of pass-through entities with more clarity over their U.S. income tax burden, as well as income or deductions from overseas interests.
The benefit of standardization is demonstrated effectively through “Part VII—Information to Complete Form 8621” for Passive Foreign Investment Company (PFIC) reporting. As with other international tax-related information, the annual PFIC information reporting was a white paper disclosure attached to a K-1. Now, the required information, such as the number and value of shares, and Qualified Electing Fund (QEF)-related ordinary earnings and net capital gains, are clearly visible in a table format.
This enhanced information should also allow the IRS to better verify that partnerships and S corporations are properly meeting their international disclosure requirements, which may reduce the need for follow-up inquiries and examinations from the IRS.
Who Needs To File Schedules K-2 And K-3?
In general, all pass-through entities with items of international tax relevance, including entities with foreign partners and international activities, will be required to use these new forms. Filers of Form 1065, Form 1120-S, and Form 8865 with cross-border activities, foreign partners or partners requiring certain information to claim foreign tax credits, may be required to file Schedules K-2 and K-3.
At the end of January 2022, the IRS posted updated instructions clarifying that pass-through entities with no foreign activity nor foreign partners or shareholders may still need to file Schedules K-2 and K-3. A specific instance is when a pass-through entity has a partner that would claim foreign tax credits on Forms 1116 or 1118. In fact, information reported on Schedule K-3 that previously may have been unavailable could change a partner’s foreign tax credit limitation.
For example, a partner with 40% ownership that has specific interest expense would benefit from information pertaining to their share of a pass-through entity’s assets generating U.S. source income (illustrated on IRS FAQ 12 - Example 1). Interest expense is sourced by the partner based on the tax book value of income-producing assets. Therefore, the more U.S. source income generating assets a partner has, the less that their interest expense will be apportioned to foreign source income. The fewer the expenses, the higher the foreign source taxable income, resulting in a higher foreign tax credit limitation. Prior to 2021, a partner’s share of a pass-through entity’s assets with only domestic activities would rarely be disclosed. In this case, the Schedule K-3 requirement may be appreciated.
Prior to the updated instructions, many pass-through entities with only domestic activities likely had not considered these new schedules. The IRS provided transition relief on February 16, 2022, with the release of IR-2022-38. The news release provides an exemption for eligible partnerships and S corporations from Schedules K-2 and K-3 filing for the 2021 tax year. Generally, this exemption applies to domestic partnerships and S corporations: with no foreign activity, no direct foreign partners, that did not provide partners or shareholders with foreign activity-related information (i.e., for Form 1065 no information on line 16, etc.) for the 2020 tax year, and has no knowledge that its partners or shareholders are requesting such information. IRS FAQ 15 further clarified that if a pass-through entity is notified by a partner of their requirement for information on Schedule K-3 prior to the filing of the tax return, then the pass-through entity must file both Schedules K-2 and K-3 with the IRS. If a pass-through entity is notified after the tax return is filed, then such information must be provided to the partner. The updated instructions include exceptions for entities that do not qualify for the exemption that limit parts of the schedules required to be completed.
What Needs To Be Reported On Schedules K-2 And K-3?
Pass-through entities must report items of international tax relevance on Schedules K-2 and K-3, which include:
• Information relevant to foreign tax credit limitation with separate reporting of income and deductions by source and category; this includes information for research and experimentation (R&E) expense, interest expense, and foreign-derived intangible income (FDII) deduction apportionment factors.
• Distributions from foreign corporations and/or information related to interests in foreign entities, including Subpart F income and Global Intangible Low-Taxed Income (GILTI) inclusions.
• Information of foreign partner's share of partnership income and deductions as U.S. source income, foreign source income and/or U.S. effectively connected income.
• Information for passive foreign investment company (PFIC) reporting, base erosion and anti-abuse tax Base Erosion and Anti-Abuse Tax (BEAT) (Section 59A), and FDII deduction.
What Are The Differences Between The Forms?
Schedule K-2 summarizes the pass-through entities’ total international distributive share of items (international tax-related income, expenses and credits). Meanwhile, Schedule K-3 is provided to each partner or shareholder with their share of international income, deductions, credits, etc.
Will The IRS Penalize Entities For Incomplete Forms?
There will be significant penalties imposed related to the new Schedules K-2 and K-3 for failure to file timely or filing incomplete returns, such as information returns, payee statements and information required under Section 6038. These penalties include Failure to File or Show Information on Partnership Return results in a penalty of $195 per month, multiplied by the number of partners during any part of the tax year (not to exceed 12 months). A complete return now includes a Schedule K-2 and K-3. Failure to File Correct Information Returns results in a minimum penalty of $50 per return [for the first-tier penalty, with a maximum penalty of $588,500 (for 2022)]. A Schedule K-3 is treated as a separate information return.
Recognizing the increased complexity in preparing these new forms, the IRS released Notice 2021-39, which provides penalty relief for incomplete or incorrect reporting for taxpayers who can establish that they made a good-faith effort to comply with the new reporting requirements.
Complying with the new schedules can create an additional level of complexity for pass-through entities. It requires solid documentation and experience with international tax standards. That is why companies with international activities should consider how they might ease their burden through the retention of services provided by seasoned professionals experienced in the intricacies of foreign tax structures and their impact on American corporations, and who are keenly aware of any changes to the U.S. tax code and can help guide organizations of all sizes with their filings.
Yuki Miyajima is a tax manager with BPM LLP.