Update: IRS provides relief for Schedules K-2 and K-3
On February 16, the IRS provided relief from the filing of Schedules K-2 and K-3 for certain pass-through entities. Learn who qualifies for this relief in our update.
Last summer the IRS finalized Schedules K-2 and K-3 and related instructions for pass-through entities (partnerships and S corporations) to use to report international-related tax information to the entities’ owners.
The first page of the instructions provides that pass-throughs that did not have “items of international tax relevance (typically international activities or foreign partners or shareholders)” would not need to complete these schedules. This gave the impression that unless you had foreign activity or foreign owners, you did not need to be concerned with these new filings.
On January 18, the IRS released supplemental guidance that states pass-through entities that have no foreign activity or owners may still need to complete these schedules and provide certain information to their owners.
This will cause additional filing complexity for pass-through entities and, as discussed below, could result in a delay in Schedule K-1s being available to owners.
Pass-throughs with no foreign activity or owners
In the January 18 posting, the IRS provided that if a pass-through entity has owners who are claiming a foreign tax credit on their own income tax return, the pass-through must complete Schedule K-2, even though the business entity had no foreign activity itself, and provide Schedule K-3 to each of its owners to report their share of the required information. Owners will receive a Schedule K-1 and K-3 in this situation.
Can this filing requirement be avoided?
In the same guidance, the IRS said that unless a pass-through entity obtains information from every direct and indirect owner showing that these owners won’t be required to file a foreign tax credit form (Form 1116 or 1118), then the pass-through entity must provide all potentially relevant information.
In separate guidance (Notice 2021-39), the IRS provided that penalties can be assessed for failure to file Schedules K-2 and K-3 unless the taxpayer establishes to the satisfaction of the IRS that it made a good faith effort to comply with the new reporting requirements.
Included in the potential penalties is the same penalty for not timely providing information to a partner/shareholder in a pass-through entity. This penalty is $210/month per partner/shareholder (for a pass-through with 10 partners, this would be $2,100 for every month the Schedule K-2 and K-3 information was not provided).
The IRS has said that the schemas required for e-filing of partnership returns with Schedule K-2 and K-3 will not be released until March 20 and not until June for S corporations.
The schemas are what the various software providers use to program the e-filing of returns, which will delay the actual filing of returns for an even longer period. For some pass-throughs (we are estimating this as fewer than 50 owners), the Schedules K-3 and K-3 can be attached as a PDF file, and the returns can be e-filed before these dates. The IRS has a restriction on PDF attachment size, so for many pass-throughs, this will not be an option, and the returns cannot be e-filed until the later dates.
Will the IRS change its mind?
This change, coming right before the start of the income tax filing season and potentially causing hundreds of thousands of pass-through entities with no foreign activity or owners to file these schedules, has led to numerous parties (including a February 10 letter signed by 30 US senators) lobbying to the IRS to take back this expanded filing requirement.
No one knows if this will happen and, just as importantly, when. Owners still need K-1 information to prepare extensions or timely file their income tax returns.
What does this mean for you?
These new schedules are significant (in some cases exceeding 19 pages), especially if there are foreign partners or foreign operations. This complexity will increase the time needed to prepare returns and, as discussed above, could impact the timing of the delivery tax information and e-filing of returns.
While there is still uncertainly on where this will end up, we recommend pass-through entities decide now whether they want to contact their owners to obtain certifications stating those owners do not need this information to prepare their own returns, or whether they want to move forward with providing Schedule K-2 and K-3 information.
If you need further assistance interpreting this new guidance and how it impacts your pass-through entity, contact Wipfli.
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