IRS Feels Your Pain on Schedules K-2 and K-3

Tax professionals frustrated with IRS rules on new international reporting requirements for passthroughs should keep in mind that the agency announced penalty relief in anticipation of hiccups with the new regime.

“The IRS recognizes these changes can cause short-term challenges, especially for flow-through entities and their preparers,” the agency said in a February 10 statement to Tax Notes.

The IRS was addressing concerns and criticism expressed by tax professionals regarding updated filing requirements for schedules K-2 and K-3 by passthrough entities and their partners and shareholders that have “items of international tax relevance.”

Partnerships and S corporations are required to report partners’ or shareholders’ total distributive share of international items on Schedule K-2 and to report a partner’s or shareholder’s allocable share of those items on Schedule K-3.

The new schedules, which took effect for tax year 2021, are intended to help partners and shareholders determine their U.S. income tax liability when a partnership or S corporation has foreign items such as deductions and credits. In a July 2020 statement announcing the release of draft schedules K-2 and K-3, the IRS noted that partners and shareholders generally obtained the international tax information they needed to report on their tax returns from their partnership or S corporation.

The entities typically conveyed that information to their partners and shareholders through a hodgepodge of supplemental statements, footnotes, or narrative statements attached to or provided with Schedules K-1. Requiring partnerships and S corporations to input that information on schedules K-2 and K-3 was intended to provide a standardized format for those entities to report international tax items to their partners and shareholders.

After the IRS finalized schedules K-2 and K-3, along with instructions, in summer 2021, many taxpayers and advisers initially assumed that the schedules needed to be filed only if a partnership or S corporation had foreign operations or foreign equity holders. But in updated instructions posted by the IRS on January 18, the agency pointed out that entities with no foreign activities or equity holders may still need to complete portions of schedules K-2 and K-3 if a partner or shareholder claims a foreign tax credit and needs information from the entity to complete Form 1116, “Foreign Tax Credit.”

On Twitter and other online platforms, tax professionals have decried the extra paperwork and questioned the rationale for requiring passthroughs with no foreign activities or equity holders to complete the schedules.

IRS Engagement

The IRS said in its statement that while schedules K-2 and K-3 clarify the information partners or flow-through investors need to accurately complete their tax returns, the schedules don’t ask for additional information. 

“Instead, the schedules are intended to improve reporting in a way that will be more useful for partners or flow-through investors, and over the longer term ease flow-through return preparation compliance by clarifying obligations and standardizing the format for reporting,” the statement says. 

The statement noted that because the IRS understood that the new reporting requirements would create compliance challenges for passthrough entities and their return preparers, the agency issued Notice 2021-39, 2021-27 IRB 3, in June 2021. The IRS said in that notice that it will provide penalty relief to filers who fall short of the new filing requirements if they make a good-faith effort to comply.

The IRS statement also pointed out that to ensure the public had an opportunity to provide input, “the IRS took the unusual step of issuing the draft Schedule K-2 and K-3 in July 2020 and held events with external stakeholders shortly after the release to seek input and feedback.”

“The comments received through all channels informed the revisions to the form, an early version of which was released in April 2021,” the statement said. “We are continuing to proceed in a manner that is informed by and responsive to stakeholder feedback and plan to issue FAQs to address questions that arise.”

Another Take

Glenn Dance of Holthouse Carlin & Van Trigt LLP, who previously questioned whether the IRS had sufficiently weighed the new reporting requirements against their administrative burdens, said the IRS’s new statement misses the point.

“The former line 16 reporting on the K-1 was more than adequate to enable investors in a purely domestic partnership to gather relevant information that they may have needed to compute their foreign tax credit amounts on Form 1116,” Dance said. “In my mind, the IRS should have continued to allow those partnerships to use the standard K-1, line 16 reporting approach, rather than forcing them into a burdensome and lengthy new reporting regime.”

Dance, who previously worked in the IRS Office of Chief Counsel, said he had a chance to weigh in on the concept of the schedules K-2 and K-3 reporting when Treasury was developing the plan.

“I understood them to be looking for a more streamlined and standardized reporting mechanism for items that didn’t fit neatly into boxes in the existing K-1, line 16 reporting,” Dance said. “They even referenced a mythical matching program that they would be able to enhance if they could standardize the international tax reporting system. There’s just no good reason they couldn’t have done all that for the folks that had those items and left the rest of us alone.”

Nathan Smith of CBIZ Inc. said that while it is generally true that the schedules don’t ask for any new information, “that single observation vastly oversimplifies the new problem.” He noted that the instructions for filers of Form 1065, “U.S. Return of Partnership Income,” state that a partnership “must presume” that its partners are eligible to claim FTCs, and therefore must complete schedules K-2 and K-3 unless the partnership has “sufficient information or notice” otherwise.  

“That is quite a leap from the world of yesteryear,” Smith said. “It doesn’t take much imagination to surmise that this information would be impossible for most partnerships to obtain, especially those with tiered ownership. All of those situations are defaulted into new filing requirements.”

The “must presume” instruction is jarring, particularly because this is the first year of reporting, but also when compared with how the IRS has handled similar situations, Smith said. “For instance, partnerships until recently were required to supply partners with gross receipts information for section 163(j) purposes only upon request from the partners,” he said. 

The 2021 instructions to Form 1065 now require that information, but in 2018 and 2019 the instructions didn’t include the harsh “presumption” language, Smith said. Instead, the previous instructions to Form 8990, “Limitation on Business Interest Expense Under Section 163(j),” said that the partners “must request the pass-through entity to separately state, in sufficient detail, the items necessary.” 

“Hence, the onus was placed on the partners, not the partnership, to cover only pertinent situations,” Smith said. “Why is that not appropriate now for schedules K-2 and K-3, at least for this first year?”

Smith said it seems like the sufficient information or notice requirement could be satisfied by the partnership or S corporation’s using negative assurance protocols. 

“For instance, the partnership could canvass its partner group with queries pertinent to Schedule K-2 and K-3 filing requirements, where such queries could inform the partner group that the partnership will assume that no triggering events exist unless a partner responds by a given date,” Smith explained. “If the partnership receives no responses, that could possibly constitute ‘sufficient information’ and therefore good-faith efforts under Notice 2021-39.”