In the past, international activity reporting has been relatively foreign — pun intended — to banks. In most cases, foreign financial reporting only applied to banks that invested in pass-through entities that paid foreign taxes, resulting in foreign tax credits passed through (on Schedule K-1) to their shareholder group.
In 2021, the IRS issued new international reporting schedules K-2 and K-3 for passthrough entities, that require more detailed reporting of international financial items with tax relevance.
At first, it seemed to be a simple determination that banks that had never done any foreign reporting would not be required to file these new schedules; however, in early 2022 the IRS updated the instructions for Schedules K-2 and K-3 to include language that alluded to a requirement that every pass-through entity (including S Corporation banks) would need to file, whether the entity had any foreign activity or not.
For 2021 tax filings, transitional relief was offered. Eligible pass-through entities without any foreign activities, foreign shareholders and without knowledge of shareholder need for information on items of international tax relevance did not need to file the new schedules.
The transitional period is ending though, and tax year 2022 will see a shift in S Corporation filing requirements, even in cases where no foreign reporting has been done before. Thus, S corporation banks will now need to consider these new international reporting requirements.
Goal of Schedules K-2 and K-3
Prior to the creation of the new Schedules K-2 and K-3, foreign reporting passed through to shareholders consisted of a few items on the face of Schedule K-1s, along with supplemental statements.
But the supplemental statements were inconsistent among tax practitioners and led to confusion by shareholders when filing their individual tax return.
Schedules K-2 and K-3 were designed to standardize foreign reporting from pass-through entities so that information is reported in a clear and consistent manner. Although reporting in the first year will take additional time and effort, eventually this should make for a smoother tax filing process for all stakeholders involved.
Who needs to file Schedules K-2 and K-3?
An entity that has international financial activity bearing tax relevance will need to file Schedules K-2 and K-3. This is much broader than it may seem. Some examples include the following:
- Any entity that has foreign source income, assets generating foreign source income or foreign taxes paid or accrued
- Any entity that has a foreign shareholder
- Any entity that has a shareholder in need of the information supplied on Schedule K-2 and K-3 to aid in filing their individual tax returns. (This last requirement will impact many S corporation banks.)
Can filing be avoided?
If the bank is not otherwise required to file Schedule K-2 and K-3, published guidance allows an exception to the filing requirement.
The bank will need to obtain information from each direct and indirect owner that the shareholder does not otherwise file a foreign tax credit form (Form 1116 or 1118) on their individual tax returns. If no shareholder indicates they need the information, filing of Schedule K-2 and K-3 will not be required for the bank.
However, if any shareholder files a foreign tax credit form (Form 1116 or 1118), then the bank must comply with the new Schedule K-2 and K-3 filing requirements.
Even after assurance from shareholders, if one shareholder subsequently informs the entity that they need the information, the bank will be required to file both Schedules K-2 and K-3.
What steps can be taken to proactively prepare for the 2022 tax filing season?
- Confirm that the bank does not otherwise have any foreign reporting requirements.
- Confirm that no shareholder needs the information provided on Schedule K-2 or K-3 to file their individual tax return, nor do they claim a foreign tax credit on Form 1116.
Will there be consequences for not filing?
There may be penalties associated with failing to file the information if it is required. These penalties will be assessed on a per shareholder/per month basis, which could become quite large for S corporation banks with large shareholder groups.
What does this mean for your bank?
Filing Schedules K-2 and K-3 may be required in conjunction with 2022 tax filings. These new schedules are longer and will likely require more time and information-gathering to complete, especially in the initial year of filing. But proactive steps can be taken now to help your bank prepare for the new filing requirements in 2022.
How Wipfli can help
The new requirements around filing Schedules K-2 and K-3 will be a big adjustment for financial institutions. Contact Wipfli to learn how this new filing requirement may impact your bank.
Sign up to receive additional financial institutions content and information in your inbox, or continue reading on: