Final Partnership Forms & Schedules to Provide Greater Clarity on International Tax Reporting for Flow-Throughs
On July 14, the U.S. Department of the Treasury (Treasury) and the IRS released a proposed redesigned partnership form for tax year 2021 (filing season 2022). The proposed form was designed to streamline the process for partners to compute their tax liability when relevant international items, such as income, deductions, and credits, are involved. The proposed form and instructions were the IRS’ attempt to streamline its ability to match a partnership’s international activity to a partner’s return.
In June 2021, the IRS released final versions of Schedules K-2, Partners’ Distributive Share Items—International, and K-3, Partner’s Share of Income, Deductions, Credits, etc.—International, that will be required for tax year 2021. Key changes were made to the final forms to reflect changes in other informational forms reporting relevant international tax items. For example, significant changes were made at the end of 2020 to Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI). Accordingly, Part IV of Schedules K-2 and K-3 was modified to reflect these changes so a partner can account for the modified reporting requirements on Form 8993. Another significant change is the addition of an information box that identifies which Parts of Schedules K-2 and K-3 are applicable to the partner/recipient. Hopefully, this will aid both the paid preparer and partner/recipient in determining what relevant international items need to be considered on the partner/recipient’s income tax return. The K-2 and K-3 filing requirements may be required for entities with no foreign activity. The IRS provided the following update to the K-2 instructions in January 2022: “A partnership with no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3. For example, if the partner claims a credit for foreign taxes paid by the partner, the partner may need certain information from the partnership to complete Form 1116.”
Partnerships traditionally attach various footnotes to Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., reporting relevant international tax items. However, these footnotes often vary in format, detail, and structure, making it difficult for the IRS to match the relevant international partnership items to a partner’s income tax return. In the absence of a standard footnote template for partnerships to use, the IRS released Schedules K-2 and K-3 to standardize this process, which should ultimately allow the IRS to better match partnership income tax returns to a partner’s income tax return as it relates to relevant international items. Furthermore, using footnote information to incorporate relevant international tax items into their own income tax returns can be difficult for partners, let alone the IRS to match said amounts. Thus, Treasury and the IRS’ intent was to enhance this information reporting process for both partnerships and partners to accurately complete income tax returns and match information. Arguably, this adds to the already burdensome international reporting requirements many taxpayers face.
As it relates to the IRS, the goal of Schedules K-2 and K-3 are to “replace, supplement, and clarify the former Form 1065, U.S. Return of Partnership Income, Schedule K, Partners’ Distributive Share Items, line 16, Foreign Transactions, and Schedule K-1, Part III, Partner’s Share of Current Year Income, Deductions, Credits, and Other Items, line 16, Foreign Transactions.” In addition, the schedules lay out in detail the necessary information for partners to gather their pro rata share of international activity for foreign tax credits (including gross income by baskets and allocable expenses), Section 250 deduction with respect to FDII, Distributions from Foreign Corporations, Subpart F inclusions, GILTI inclusions, PFICs, Section 59A (BEAT) information, and ECI. Below is a breakout of the Parts and their respective information:
Part I – Partnership’s Other Current Year International Information
Part II – Foreign Tax Credit Limitation
Part III – Other Information for Preparation of Form 1116 or 1118
Part IV – Partner’s Section 250 Deduction with Respect to FDII
Part V – Distributions From Foreign Corporations to Partnership
Part VI – Information on Partners’ Section 951(a)(1) and Section 951A Inclusions
Part VII – Information to Complete Form 8621
Part VIII – Partnership’s Interest in Foreign Corporation Income (Section 960)
Part IX – Partners’ Information for Base Erosion and Anti-Abuse Tax (Section 59A)
Part X – Foreign Partners’ Character and Source of Income and Deductions (ECI)
Part XI – Section 871(m) Covered Partnerships
Part XII – Reserved for Future Use
S Corporations & Foreign Partnerships
S corps and foreign partnerships also will be required to prepare Schedules K-2 and K-3 for the 2021 tax year. The purpose of these schedules reflects the same intent as it does for U.S. partnerships. S corp and foreign partnership disclosures on Schedules K-2 and K-3 are similar to a U.S. partnership’s reporting requirements but may vary in the Parts to be completed.
Links to the schedules and instructions (Form 1065) are outlined below:
- Schedule K-2 – 2021 Schedule K-2 (Form 1065) (irs.gov)
- Schedule K-2 Instructions – 2021 Partnership Instructions for Schedules K-2 and K-3 (Form 1065) (irs.gov)
- Schedule K-3 – 2021 Schedule K-3 (Form 1065) (irs.gov)
- Schedule K-3 Instructions – 2021 Partnership Instructions for Schedules K-2 and K-3 (Form 1065) (irs.gov)
Links to all forms, i.e., 1065, 1120-S, and 8865, and instructions via forms and publications search:
- U.S. Partnership, S Corp and Foreign Partnership K-2 Forms and Instructions – Forms and Publications (PDF) (irs.gov)
- U.S. Partnership, S Corp and Foreign Partnership K-3 Forms and Instructions – Forms and Publications (PDF) (irs.gov)
Late Notice Relief (Notice 2021-39)
Section 3 of Notice 2021-39 provides transition relief related to compliance penalties resulting from the failure to completely and accurately file new Schedules K-2 and K-3 for taxable years that begin in 2021 (processing year 2022). During the transition period, an entity required to file Forms 1065, 1120-S, or 8865 will not be subject to penalties outlined in Section 2 of the Notice if the filer establishes that it made a good faith effort to comply with the Schedules K-2 and K-3 filing requirements. However, a Schedule K-2 and K-3 filer that does not establish that it made a good faith effort to comply with the new requirements will not be eligible for penalty relief under the Notice. The Notice provides several examples of acts the IRS will consider to be made in good faith.
The Schedules K-2 and K-3 reporting requirement will create more compliance in an already complex international reporting environment. Preparers need to take steps now to help ensure their workpapers and preparation software are in place to handle these changes come next filing season. Also, code changes to other areas of international tax (as previously mentioned) may affect the various Parts on the K-2 and K-3, and it can be complicated to determine their impact on these schedules. At a minimum, the IRS recognizes this issue by issuing Notice 2021-39. However, preparers could perceive Notice 2021-39 to be far reaching. For example, the notice states the following:
“In general, in the taxable year 2021 instructions, unless the Schedule K-2/K-3 filer has knowledge to the contrary, it must file or complete certain parts assuming that the information would be relevant to the partner or shareholder.”
For example, assume an operating partnership builds and sells widgets in the ordinary course of business. Assuming only U.S. individual partners, the partnership would not need to file the BEAT section of K-2/K-3 as it only applies to certain corporations. However, if the same partnership has a flow-through entity partner, at a minimum, the preparer may have to complete the BEAT sections and the FDII sections (Parts IV and IX) because the preparer has to assume that the flow-through entity owner has a direct or indirect corporate partner (unless the partnership has sufficient information to confirm that there is no indirect corporate owner).
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