New Schedules K-2 and K-3: What Partnerships and S Corporations Can Expect in the First Year of Reporting
Partnerships, S corporations, and U.S. persons with interests in foreign partnerships may have to file Schedules K-2 and K-3 with the returns they file in 2022 for tax years beginning in 2021. Specifically:
- S corporations with “items of international tax relevance” must file Schedule K-2, Shareholders’ Distributive Share Items—International; and Schedule K-3, Shareholder’s Share of Income, Deductions, Credits, etc.—International.
- Partnerships with “items of international tax relevance” must file Schedule K-2, Partners’ Distributive Share Items—International; and Schedule K-3, Partner’s Share of Income, Deductions, Credits, etc.—International.
An S corporation files the schedules with its Form 1120-S. A partnership files the schedules with its Form 1065 or Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. The S corporation or partnership must also provide Schedule K-3 to its shareholders or partners. However, the IRS may waive penalties for filers that fail to comply with the new rules.
Who Must File Schedules K-2 and K-3?
The new schedules must be filed by all pass-through entities with items of international tax relevance, including foreign partners and international activities. However, pass-through entities with no international tax items to report do not have to file the schedules.
Items of international tax relevance include information partners and shareholders need to determine their:
- foreign tax credits (income or loss by source and separate category of income);
- IRC §250 deduction with respect to foreign-derived intangible income (FDII);
- inclusions of subpart F income and Global Intangible Low-Taxed Income (GILTI); and
- distributions from a foreign corporation that are treated as dividends or excluded from gross income because they are attributable to previously taxed earnings and profits (PTEP).
Purpose of New Schedules K-2 and K-3
The new Schedule K-2 and Schedule K-3 replace and supplement the reporting of items that were previously reported (often in less detail) on Schedules K and K-1. The new schedules:
- standardize the format and methods for the international reporting for pass-through entities;
- help pass-through entities provide partners and shareholders with information necessary to complete their own tax returns;
- provide clarity to partners and shareholders preparing their returns; and
- allow the IRS to better assess compliance.
Transition Period Penalty Relief for Schedules K-2 and K-3
The IRS acknowledges that reporting and compliance challenges may arise when filing the Schedules K-2 and K-3. For example, filers may not have systems or procedures in place to obtain the detailed information required to determine whether and how they must file a part of the new schedules.
Thus, for tax years beginning in 2021 (returns filed in 2022), penalties will not be imposed for incorrect or incomplete reporting on Schedules K-2 and K-3, if the partnership or S corporation establishes that it made a good faith effort to comply with the requirements to file or furnish the schedules.
Good Faith Efforts to Comply
When determining whether an entity made a good faith effort to comply with the Schedule K-2 and K-3 requirements, the IRS will consider the extent to which the filer:
- changed its systems, processes, and procedures for collecting and processing relevant information;
- obtained information from partners, shareholders, or a controlled foreign partnership (CFP), or applied reasonable assumptions when information is not obtained; and
- took steps 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.
The IRS will also evaluate the entity’s efforts to obtain relevant information about partners, shareholders, or CFPs. Given the wide variety of relationships that exist between Schedule K-2/K-3 filers and partners/shareholders, the entity might fail to obtain the required information despite its good faith efforts to do so.