The IRS Again Eases Schedules K-2 and K-3 Filing Requirements for 2021
The IRS has announced additional relief for those pass-through entities that are required to file two new tax forms — Schedules K-2 and K-3 — for the 2021 tax year. While certain domestic partnerships and S corporations will not be required to file them, schedules K-2 and K-3 are intended to make it easier for partners and shareholders to find information related to “items of international tax relevance” that they need to report on their own individual returns.
In Notice 2021-39, the IRS released guidance providing penalty relief for filers who made “good faith efforts” to adopt the new schedules. More recently, in response to continued concern and feedback from taxpayers and practitioners, the IRS has indicated that under certain circumstances taxpayers will be entirely relieved of the need to file the new forms this year.
A tough tax season for the IRS
The announcement of additional relief comes as IRS Commissioner Charles Rettig has acknowledged that the agency faces “enormous challenges” this tax season. For example, millions of taxpayers are still waiting for prior years’ returns to be processed thanks to a monumental backlog.
To address such issues, he says, the IRS has taken “extraordinary measures,” including mandatory overtime for IRS employees, the creation and assignment of “surge teams,” and the temporary suspension of the mailing of certain automated compliance notices to taxpayers. In addition, the partial suspension of the filing requirements for Schedules K-2 and K-3 might ease the burden for both affected taxpayers and the IRS.
K-2 and K-3 filing requirements
Provisions of the Tax Cuts and Jobs Act, which was enacted in 2017, require taxpayers to provide significantly more information to calculate their U.S. tax liability for items of international tax relevance. The Schedule K-2 reports such items, and the Schedule K-3 reports a partner’s distributive share of those items.
Schedules K-2 and K-3 must be filed with a partnership’s Form 1065, “U.S. Return of Partnership Income,” or an S corporation’s Form 1120-S, “U.S. Income Tax Return for an S Corporation.” These new schedules require more detailed and complete reporting than the entities may have provided in the past.
Schedules K-2 and K-3 replace portions of Schedule K and numerous unformatted statements attached to earlier versions of Schedule K-1. Previously, partners and S corporation shareholders could obtain the information included on the schedules through various statements or schedules the respective entity opted to provide, if any.
In January of 2022, the IRS surprised many in the tax community when it posted changes to the instructions for the schedules. Under the revised instructions, an entity may need to report information on the schedules even if it had no foreign partners, foreign source income, assets generating such income, or foreign taxes paid or accrued.
For example, if a partner claims a credit for foreign taxes paid, the partner might need certain information from the partnership to file his or her own tax return. Although some narrow exceptions apply, this change expanded the pool of taxpayers required to file the schedules.
Under the latest guidance, announced February 16th through an IRS FAQ, partnerships and S corporations do not need to file the schedules if they satisfy all the following requirements for the 2021 tax year:
- The direct partners in the domestic partnership are not foreign partnerships, corporations, individuals, estates or trusts, and
- The domestic partnership or S corporation has no foreign activity, including 1) foreign taxes paid or accrued, or 2) ownership of assets that generate, have generated or may be expected to generate foreign-source income.
- For the 2020 tax year, the domestic partnership or S corporation did not provide its partners or shareholders — nor did they request — information regarding any foreign transactions.
- The domestic partnership or S corporation has no knowledge that partners or shareholders are requesting such information for the 2021 tax year.
Entities that meet these criteria are not required to file Schedules K-2 and K-3. But there is an important caveat; if such a partnership or S corporation is notified by a partner or shareholder that it needs all or part of the information included on Schedule K-3 to complete its tax return, the entity must provide that information.
Moreover, if the partner or shareholder notifies the entity of this need before the entity files its own return, the entity no longer satisfies the criteria for the exception. As a result, it must provide Schedule K-3 to the partner or shareholder and file the schedules with the IRS.
“Good faith exception”
In addition to the FAQ exemption, Notice 2021-39, released in June 2021, exempts affected taxpayers from penalties for the 2021 tax year if they make a good faith effort to comply with the filing requirements for Schedules K-2 and K-3. While some are calling this a “good faith” exception, there’s some irony in this, given that the IRS is not exactly acting in good faith itself.
When determining whether a filer has established such an effort, the IRS considers, among other things:
- The extent to which the filer has made changes to its systems, processes, and procedures for collecting and processing the information required to file the schedules;
- The extent to which the filer has obtained information from partners, shareholders, or a controlled foreign partnership or, if not obtained, applied reasonable assumptions; and
- The steps taken by the filer 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 the schedules.
The IRS will not impose the relevant penalties for any incorrect or incomplete reporting on the schedules if it determines the taxpayer exercised the requisite good faith efforts.
Both the IRS FAQ exception and the “good faith exception” explicitly refer to 2021 tax year filings. In the absence of additional or updated guidance, partnerships and S corporations should expect and prepare to file the schedules for 2022 and later tax years.
MGO tax advisors are available
If you have questions, MGO can help. Please reach out to our partnership and international tax professionals for assistance. We can help ensure that you stay in compliance with these new requirements.