Beginning with the 2021 tax year, certain partnerships and S corporations must use Schedules K-2 and K-3 to report items of international tax relevance to their partners and shareholders. Generally, Schedules K-2 and K-3 replace the reporting that was previously done on Box 16 of Schedule K and K-1 and streamline reporting of certain items that historically would have been represented on footnotes or attachments to Schedule K-1.
Based on initial IRS guidance, partnerships and S corporations that had “items of international tax relevance (typically, international activities or foreign partners)” would be required to file the Schedules K-2 and K-3. The Schedules K-2 and K-3 are divided into multiple “Parts,” each of which has filing instructions and guidance on determining whether that particular “Part” is relevant or required to be completed. Generally, in most cases, the presumptions in the IRS guidance favors filing the schedules where there is any uncertainty, i.e., that is when the identity or status of certain direct or indirect partners cannot be determined.
On January 18, the IRS released additional instructions and clarifications for Schedules K-2 and K-3, specifically in relation to who must file:
Therefore, many partnerships and S corporations with only domestic activities, or domestic activities and partners, may be required to file Schedules K-2 and K-3 for the 2021 tax year. Unless the reporting partnership can establish with certainty that it does not have direct or indirect foreign partners, direct or indirect corporate partners, or domestic partners who may file Form 1116 or 1118, the reporting partnership will be required to presume their partners have a filing requirement and therefore should complete the relevant Parts of Schedules K-2 and K-3.
Generally, a partnership or S corporation would need to meet an exception to specific Parts of the form to be relieved of filing those Parts of Schedules K-2 and K-3. Accordingly, such taxpayers may wish to plan to file Schedules K-2 and K-3 unless it can be affirmatively confirmed whether a specific exception to filing for the relevant Parts of Schedules K-2 and K-3 has been met.
On February 16, 2022, the IRS released several FAQs providing additional guidance regarding Schedules K-2 and K-3. The FAQs confirm that in many instances, a partnership or S corporation with no foreign partners, foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3.
The IRS FAQs also provide an additional exception for the tax year 2021 to filing the Schedules K-2 and K-3 for certain domestic partnerships and S corporations. The following criteria must be met to qualify for this exception:
If a partnership or S corporation qualifies for this exception, the domestic partnership or S corporation does not need to file Schedules K-2 and K-3 with the IRS or with its partners or shareholders. However, if the partnership or S corporation is subsequently notified by a partner or shareholder that all or part of the information contained on Schedule K-3 is needed to complete their tax return, then the partnership or S corporation must provide the information to the partner or shareholder. If a partner or shareholder notifies the partnership or S corporation before the partnership or S corporation files its return, the conditions for the exception are not met, and the partnership or S corporation must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS.
Heading into the filing season for 2021 tax returns, it is important to note the following:
Further, e-filing requirements for Schedules K-2 and K-3 will not be available until late March. Please note, on January 18, the IRS released additional instructions for the Schedules K-2 and K-3. Those updates are not incorporated into the 2021 instructions.