Since the enactment of the Tax Cuts and Jobs Act in 2017, the IRS made significant changes to the Schedule K1. The changes require taxpayers to provide significantly more information to calculate their tax liability for items of international tax implications. The new K2 form reports such items and the Schedule K3 reports a partners’ share of said international items.
The new schedules must be filed along with the partnership’s Form 1065 or an S Corps’ Form 1120S. These new schedule require more detail and complete reporting than in past years.
This past January, the IRS surprised many tax preparers with sudden changes to the instructions for the schedules. Under these new revisions, the entity needs to report information on the schedule EVEN IF it had no foreign partners, sources of income, assets generating income, or foreign taxes paid. An example is if a partners claims a foreign tax credit the partner will need certain information from the partnership to file his/her own personal taxes. This significantly expanded the pool of taxpayers required to file the K2 and K3 schedules.
IRS Notice 2021-39 exempted affected taxpayers from penalties for the 2021 tax year if a good faith effort was made to comply with the K2 and K3 filing requirements. The IRS established the following criteria to determine such good faith.
- 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 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’s relevant to determining whether and how to file the schedules.
Guidance as of February 2022
Partnerships & S Corps need not file the schedules if the following is satisfied:
- For the 2021 tax year:
- The direct partners in the domestic partnership aren’t 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 reasonably be expected to generate foreign-source income.
- For the 2021 tax year:
- For the 2020 tax year, the domestic partnership or S corporation didn’t 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.
However, there is an exception. If a Partner notifies the partnership or S Corp that it needs the information included on the K3 in order to complete its tax return, the information must be supplied. Then the partnership must also file the schedule with the IRS.
The IRS and subsequently, tax preparers have faced enormous challenges this tax season due to the K2 and K3 requirements and guidance as well as lack of available forms. As it stands, millions of taxpayers are still waiting for prior years’ returns to be processed. The IRS has implemented mandatory overtime, surge teams, and temporary suspension of certain automated compliance notices to tax payers. Additional help came from easing the requirements and partial suspension of Schedule K2 and K3 requirements.