K-2/K-3 Filing Requirements
By: Cooper Melvin, JD, CPA
Taxpayers owning an interest in certain partnerships or S corporations may have noticed additional information in the Schedule K-1 package for 2021 regarding international tax matters. Beginning with tax year 2021, the IRS is requiring the filing of Schedules K-2 and K-3 if a pass-through entity contains “items of international tax relevance (typically, international activities or foreign partners).” These schedules supplement Schedule K-1 to report items such as foreign-sourced income and foreign taxes paid as well as other information of international tax relevance.
The IRS has broadly defined items of international tax relevance. For example, earlier this year, IRS guidance clarified that pass-through entities that have owners claiming a foreign tax credit may be required to file Schedules K-2 and K-3, even if the entities have no foreign-source income or offshore assets. The reason for this position is that income and deduction sourcing information may be relevant for partners claiming a foreign tax credit. The burden under this clarification could be significant for entities and their tax preparers. In response to feedback from the tax community, the IRS has provided some relief for the 2021 tax year. Penalty relief will be available for good faith efforts to comply with the filing requirement, even if improperly reported. Also, if a pass-through entity has no foreign owners or foreign activities and no knowledge of an owner’s need for information on items of international relevance, then it is exempt from the filing requirement. If an entity is notified by owners that information contained on the new schedules is needed to complete their returns, then the entity must provide the information to the owner.
While items of international tax relevance have always been reportable on the Schedule K-1, there has never been a standardized form or way in which to report it. In general, Schedules K-2 and K-3 replace reporting that was previously marked in Box 16 on Schedule K-1 or as other footnotes or attachments to Schedule K-1. The inconsistencies in these footnotes and attachments lead to much of this information being left off of the owners’ personal returns due to confusion over what is considered informational versus what is reportable on 1040s. Therefore, the IRS created the new requirement to standardize reporting for consistency purposes. The goal is to make it easier on the preparer of the owners’ individual returns to correctly report the foreign items on the 1040, especially when a different professional prepares the entity return and the individual return.
Whether you are an owner of a pass-through entity receiving Schedules K-2 and K-3 for the first time, or a pass-through entity trying to decide if you should file Schedules K-2 and K-3 for 2021, please contact your BMSS professional for further clarification on the reporting requirements.