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February 17, 2022

How To Navigate New Pass-Through Entity Schedules K-2 and K-3 to Avoid Confusion When Filing

In early 2021, the IRS announced changes to the required tax forms for pass-through entities by introducing Schedules K-2 and K-3. Both are meant to expand upon items of international relevance to the owners of the entities.

The two forms will be required for partnerships, S-corporations, and some Form 8865 filers. The IRS is attempting to provide more transparency and clarity for individual tax filers to assist in calculating foreign tax credits and income that were traditionally picked up on Schedule K-1 and footnoted accordingly. The IRS is also further automating the processing of returns so that the IRS can process them more efficiently.

These new schedules can be cumbersome depending on the number of items of international relevance that the pass-through entity has (19 pages and 20 pages for Schedules K-2 and K-3, respectively). Schedule K-2 will align with Schedule K, breaking out the international tax items much more granularly than was previously listed on Schedule K Line 16. Schedule K-3 will substantially mirror the Schedule K-1 Line 16 items previously reported with footnotes to the K-1s.

Analyzing the necessity for these new forms comes with some potential hurdles, as it could require pass-through entities to gain more clarity into its owners’ personal reporting, as well as an analysis of indirect ownership. Per updated instructions issued in February 2022, even if any entity has no foreign income or activities there may still be a filing requirement based upon the owner’s eligibility to claim foreign tax credits.

The IRS has issued Notice 2021-39, which states the IRS will make available certain transition penalty relief for the 2021 tax-year assuming a good faith effort is to comply with the new reporting requirements. Entities should start assessing the impact for the future tax years regarding additional filing requirements necessary based on the direct and indirect structure.

Organizations should anticipate the additional time and fees associated with the analysis and preparation of these new forms during this transition year and should continue to monitor further clarification and updates communicated by the IRS. Recent correspondence from the IRS has mentioned that the new schedules are not projected to be available for e-filing purposes until after the March 15th deadline for partnerships. For S-corporations, the e-filing acceptance of these new forms may not begin until late June.

As a solution to the above, entities will need to assess whether it is more prudent to go on extension and file their final tax returns after the forms are available for e-file, or to attach Schedules K-2 and K-3 to their otherwise completed tax returns as an e-file attachment.

For questions or concerns about the new schedules, and how it may impact your structures reporting requirements, please reach out to an MGO advisor today for help navigating these new and extensive requirements.