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Insuring the New Schedules K-2 and K-3

To learn more about the new Schedules K-2 and K-3, see the IRS’s news release and FAQs on February 16, 2022.

To prepare these very long and complicated schedules in time for the 2021 tax filing season, tax return preparers were concerned. For the 2021 tax year, the IRS has granted transition relief to certain domestic partnerships and S corporations. However, tax return preparers and clients should prepare and file new Schedules K-2 and K-3 now, as further relief is unlikely.

The IRS created new Schedules K-2 and K-3 to help partners and S corporation shareholders report “items of international tax relevance”. Previously, partners and S corporation shareholders had to rely on whatever statements or schedules the partnership or S corporation provided. The IRS deserves credit for creating a reporting mechanism that standardises and improves this data.

The outcry arose after the IRS posted changes to the new schedules instructions on January 18, 2022. The revised instructions stated:

A partnership with no foreign income, no foreign assets, and no foreign taxes paid or accrued may still be required to file Schedules K-2 and K-3. For example, if a partner claims a credit for foreign taxes paid, the partnership may need to complete Form 1116.

A domestic partnership or S corporation with no foreign activities and no foreign partners or shareholders was not required to attach Schedules K-2 and K-3 to its IRS Form 1065 or 1120-S, respectively. Tax professionals were outraged because this change required a partnership or S corporation with any direct or indirect partners or shareholders claiming foreign tax credits to complete these new schedules.

FAQ #15 of the IRS’s most recent guidance includes transitional relief for 2021. Schedules K-2 and K-3 for 2021 are not required for domestic partnerships and S corporations that meet all of the following criteria:

In 2021, the domestic partnership’s direct partners are not foreign partnerships, corporations, individuals, estates, or trusts.

It has no foreign activity in 2021, no foreign taxes paid or accrued, and no foreign assets owned (see Treas. Reg. 1.861-9(g)(3)).
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 (Controlled Foreign Corporations, Passive Foreign Investment Companies, 1120-F, section 250, section 864(c)(8), section 721(c) partnerships, and (line 17d for Form 1120-S).
In the case of a domestic partnership or S corporation, the partners or shareholders are unaware.
While this is good news for many tax preparers, if a domestic partnership or S corporation that qualified for temporary relief is notified by a partner or shareholder that information from Schedule K-3 is required to complete their tax return, the partnership or S corporation must provide it. The exception does not apply if a partner or shareholder notifies the partnership or S corporation that it needs this information before the partnership or S corporation files its 2021 US tax return.

IRS Form 1065 is not required for foreign partnerships with no effective connection to the US. Schedules K-2 and K-3 are not required if a partnership does not have to file IRS Form 1065. In light of the recent guidance, tax return preparers should consider what additional steps they should take to properly complete and file Schedules K-2 and K-3 going forward.

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Leo K. Nelson

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