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IRS Provides Workaround on Filing Schedules K-2, K-3

Posted on Dec. 8, 2021

The IRS has explained how passthrough entities with short tax years can comply with new international reporting requirements if tax year 2021 forms aren’t finalized at least 30 days before the return due date.

The workaround for reporting international tax items on schedules K-2 and K-3 was provided in two FAQs posted on the IRS website December 7.

The new schedules, which took effect for tax year 2021, apply to passthroughs and their partners and shareholders that have “items of international tax relevance,” which typically means foreign activities or foreign partners.

The IRS noted in the FAQs that schedules K-2 and K-3, along with their instructions, were finalized over the summer, but the tax returns to which they must be attached (forms 1065, 1120-S, and 8865) haven’t been finalized yet. That has prompted taxpayers with short tax years to ask how they should prepare their returns.

FAQ 1 addresses filers with short tax years for whom the final version of the relevant 2021 form isn’t available at least 30 days before the return due date. In those cases, filers must use tax year 2020 forms and incorporate any tax law changes effective for the 2021 tax year, the FAQ says. It added that penalties won’t be imposed on those filers for failing to attach schedules K-2 and K-3 to the tax year 2020 forms.

That treatment is consistent with Notice 2021-39, 2021-27 IRB 3, which provides some penalty relief in recognition of the complexity involved in preparing the new schedules. “The Notice will apply with respect to information that would have been reported on the Schedules K-2 and K-3, but that is provided by completing the tax year 2020 Forms with attachments as described below,” the FAQ says.

Filers using tax year 2020 forms must follow the accompanying instructions on reporting international transactions and items of international tax relevance on schedules K and K-1, and they must include the information required by schedules K-2 and K-3 and the instructions for those schedules, the FAQ says.

“If you choose, you may attach Schedules K-2 and K-3 (in pdf format) to the tax year 2020 Forms, and these schedules should be completed by following the tax year 2021 instructions for those schedules,” the FAQ says.

FAQ 2 stresses that the exception from filing schedules K-2 and K-3 applies only to filers that meet the conditions described in FAQ 1. It notes that everyone else — that is, filers with accounting periods beginning on or after January 1, 2021, and for whom the final version of the relevant 2021 form is available at least 30 days before the return due date — must attach schedules K-2 and K-3 to the 2021 form.

According to Glenn Dance of Holthouse Carlin & Van Trigt LLP, the FAQs “will be very helpful for a very small number of partnerships.”

“The need to file short-period partnership returns used to be a fairly common occurrence, prior to the repeal of the technical termination rules” as part of the Tax Cuts and Jobs Act, Dance told Tax Notes. "But it is far less common these days.”

Because the FAQs don’t address other outstanding questions on the new filing requirements, Dance said he expects that taxpayers and advisers will continue to clamor for additional guidance.   

“For example, I have heard that at least one of the large accounting firms has advised its clients that they should be including these onerous new filings with all of their partnership returns, unless they can prove that none of their direct or indirect partners — such as persons holding interests through upper-tier partnerships — have any of the relevant international tax issues,” Dance said.

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