The IRS created new Schedules K-2 and K-3 for the 2021 tax year, and there has been uncertainty surrounding this complex topic ever since. On December 23, 2022, the IRS finalized instructions for 2022 Schedules K-2 and K-3 for partnerships and S-Corporations, further modifying confusing provisions and providing relief for certain domestic partnerships and S-Corporations that applied for 2021.
What Are Schedules K-2 and K-3?
The IRS created Schedules K-2 and K-3 to provide greater certainty and consistency in reporting international information to partners and shareholders. For tax years beginning in 2021, a partnership was required to file Schedule K-2 and Schedule K-3 if the entity had certain international tax items. Schedule K-2 summarized these items for all partners while Schedule K-3 provided information for each partner. S-Corporations with international tax items also had similar filing requirements.
These schedules were intended to provide owners of affected pass-through entities the information they need to calculate their U.S. income tax liability from international items. The new schedules were designed to replace the inconsistent approaches being used by pass-through entities to report this information to owners with a standard format which would provide more detail.
Late filing penalties of $210 per month per partner or shareholder, in addition to a $280 penalty per partner or shareholder for failure to furnish information, could apply if the schedules were not properly completed. Notice 2021-39 granted transition relief for taxable years which began in 2021 for any incorrect or incomplete reporting on Schedules K-2 or K-3 if the filer established that it made a good faith effort to comply.
Limited Reporting Relief During 2021
In a news release issued on February 16, 2022, the IRS granted exceptions to the Schedule K-2 and K-3 filing requirement for pass-through entities that satisfied the following requirements:
- In tax year 2021, the direct partners or shareholders in a domestic partnership or S-Corporation were not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts.
- In tax year 2021, the domestic partnership or S-Corporation had no foreign activity, including foreign taxes paid or accrued or ownership of assets that had generated or were reasonably expected to generate foreign source income.
- In tax year 2020, the domestic partnership or S-Corporation did not provide to its partners or shareholders nor did the partners or shareholders request the information regarding (on the form or attachments thereto):
- Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S), and
- Line 20c, Form 1065, Schedules K and K-1(line 17d for Form 1120-S)
- The domestic partnership or S-Corporation had no knowledge that the partners or shareholders were requesting such information for tax year 2021.
Revised Domestic Filing and Form 1116 Exceptions for 2022
On December 23, 2022, the IRS finalized instructions for Schedules K-2 and K-3 for partnerships and S-Corporations for tax year 2022. However, this latest round of filing relief may be more difficult to achieve.
The domestic filing exceptions requirements include:
- No or limited foreign activity.
- The partners or shareholders of the pass-through entity are limited to U.S. citizens, individual resident aliens, domestic decedent estate, domestic grantor trust, domestic non-grantor trust, S-Corporation with sole shareholder, and single member limited liability companies;
- Written notice has been provided to the partners and shareholders that they will not receive Schedule K-3 unless the partner or shareholder requests the schedule; and
- The partnership or S-Corporation has not received a request for Schedule K-3 from any partner or shareholder one month prior to filing its Form 1065.
A Form 1116 Filing Exception can apply where the pass-through entity does not qualify for the domestic filing exception and all partners are not required to file Form 1116. The pass-through entity must receive notice from the partners or shareholders no later than one month before the tax return is filed or one month before the tax return due date, including extensions that no K-3s will be needed. If not all partners or shareholders provide the pass-through entity with the required notice of exemptions, the pass-through entity must complete the Schedule K-2 but only need provide Schedule K-3 to the individuals who have not provided notice of exemption.
Transition Period Penalty Relief No Longer Available in 2022
For tax year 2021, penalty relief for a pass-through entity that exercised good faith in its reporting effort was provided to ease the original transition period. For tax year 2022, that relief has been rescinded. Pass-through entities can anticipate penalties if the schedules are not completed in their entirety when required or are not completed and furnished to the respective partners timely.
Recommendation for 2022
Even if the owners of a partnership or S-Corporation are confident that the entity is clearly a domestic partnership having no or very minimal passive foreign source income or foreign tax credits, and no foreign activity, we still recommend issuing Schedules K-2 and K-3 when filing 2022 pass-through entity tax returns. This approach can help reduce the risk inherent with not being fully aware of every partner’s or shareholder’s individual circumstances, as well as avoid having to scramble should partners or shareholders request a Schedule K-3.
We recognize that this continues to be a complex topic, despite efforts by the IRS to provide clarity. If you have any questions or concerns about Schedules K-2 and K-3, including whether you have a filing requirements or whether certain international transactions would be applicable, please contact your Kreischer Miller relationship professional or any member of our Tax Strategies group.
Michael R. Viens can be reached at Email or 215.441.4600.
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