International-related Schedules K-2/K-3 are causing headaches during this tax filing season as reporting is required for items with international relevance, including U.S. source income.
In June 2021 the Internal Revenue Service (“IRS”) released final versions of two new international-related schedules to be included as part of 2021 pass-through entity tax returns:
- Schedule K-2, Partners’ Distributive Share Items — International
- Schedule K-3, Partner’s Share of Income, Deductions, Credits, etc. — International
These new schedules were designed to be attached to Schedules K-1 to provide more clarity for partners and shareholders on how to calculate their U.S. income tax liability, as well as international information reporting requirements.
At the outset, the IRS determined the forms should be completed by pass-through entities with items of “international relevance” which was met with varying degrees of interpretation in the tax community.
The IRS subsequently released updates and amendments in late January of this year clarifying that a pass-through entity with no foreign partners or shareholders, no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued would still need to complete Schedules K-2 and K-3. Despite having only domestic operations, the information contained in the Schedules K-2/K-3 is used to assist partners/shareholders in completing Form 1116 or 1118 and calculate their applicable foreign tax credit.
As a result of this clarification, pass-through entities would be required to provide Schedules K-2/K-3 to partners and shareholders unless notified by all partners/shareholders in each entity that this information is not needed to complete any foreign tax credit filings.
The IRS has indicated that failure to file these Schedules K-2/K-3 properly can lead to penalties approaching $2,500 per partner/shareholder (in addition to other international information reporting penalties); these penalties are not automatic. However, the IRS has indicated if you make a “good faith effort” these penalties could be abated in the first year.
On Tuesday evening, the IRS posted the following on its website:
February 15 update
Coming relief from certain Schedule K-2 and K3 reporting: The IRS intends to provide certain additional transition relief for this year from the Schedule K-2 and K-3 reporting for certain domestic partnerships and S corporations with no foreign activities, foreign partners or shareholders, and without knowledge of partner or shareholder need for information on items of international relevance. For 2021, these qualifying domestic partnerships and S corporations will not have to file the new schedules. We are taking this step in response to feedback we received from the tax community and our stakeholders. The IRS will provide full details of this relief soon.
While the details regarding the transitional relief remain unclear at this time, this is evolving quickly and Wolf & Company’s international and pass-through teams are monitoring all updates and releases. Further communication will be released when more information is made available.
Increased Demands on an Already-Strained System
These new reporting schedules require a level of detail practitioners have not previously seen in the pass-through reporting regime. Further, the information contained in these forms floods an Internal Revenue Service that is already behind.
The IRS letters and halted collection activities while it works through a severe backlog of 24 million unprocessed tax returns as well as an unknown amount of other unopened mail.
In a letter dated February 10, Senators from the Senate Finance Committee urged the IRS to consider options to alleviate the backlog and consider postponing the implementation of Schedules K-2/K-3.
What Does This Mean For You?
Taxpayers and practitioners have already spent countless hours adjusting internal processes to account for these increased reporting requirements. However, these new forms also require updates to tax software and electronic filing systems to ensure proper transmittal of this information to the IRS.
To that end, tax software providers have not received final schemas from the IRS to allow forms to calculate properly. Additionally, without the final electronic filing schema, we are unable to transmit these tax returns the IRS. Partnership schemas are expected late March and S corporation schemas are expected mid-June. While tax software providers have indicated PDFs of these forms can be attached for e-filing, the IRS has a restriction on PDF attachment size making this a non-viable option for many partnership and S corporation filers. As such, taxpayers should expect to file extensions as there will be significant delays this season for a significant population of partnership and S corporation tax returns.
Unfortunately, we are left to follow the timelines of the IRS schemas being finalized and delivered to the industry tax software providers. Until the tax software providers have the appropriate data from the IRS to properly prepare these new Schedules K-2/K-3, accuracy and limiting risk of penalty exposure is our utmost priority.
Clients that have historically received tax returns prior to the April 15th tax filing deadline should expect discussions with their tax preparers regarding draft tax returns being provided this filing season instead. Extensions related to timing of partnership and S corporation tax returns will result in extensions for all other taxpayers that typically receive Schedule K-1s from these entities. Further, these complexities in reporting will likely result in tax return preparation fee increases. Engagement teams will be reaching out to those impacted.
The international and pass-through tax teams at Wolf & Company are constantly monitoring IRS releases in this space and remain in daily contact with our tax software providers to ensure timely and proper reporting for all clients.