Widespread Consequences of Schedules K-2 & K-3
There have been discussions regarding the applicability of Schedules K-2 and K-3 since their release last year. Taxpayers and practitioners may be surprised by the potential widespread applicability of Schedules K-2 and K-3.
The instructions state that Schedules K-2 and K-3 are only required for partnerships and S corporations with items of international tax relevance. The term “international tax relevance” was met with a varying degree of interpretation, which resulted in the IRS releasing clarifications and amendments to the form instructions. The most recent glaring update was to the “Who Must File” section. The instructions clarify that partnerships and S corps may be required to complete Schedules K-2 and K-3 even if the partnership or S corp has no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued.
One reason for this is because if a partner or shareholder claims a foreign tax credit on Form 1116 or 1118 (even on income generated from other sources, such as foreign passive income earned through a brokerage account), detailed information from all sources, within and without the U.S., is needed to accurately complete Form 1116 or 1118.
This methodology also applies to corporate partners who are required to file other tax forms related to international provisions at the corporate level, such as Forms 8991, 8992, and 8993. Therefore, items that are of international tax relevance should be identified and determined at the partner level and be inclusive of information to be reported from domestic sources. IRS Notice 2021-39 indicates the IRS will provide penalty relief for 2021 Schedule K-2 and K-3 filings for pass-through entities that have made a good faith effort for determining what parts of the forms apply to its partners. It is advised to assume that Schedules K-2 and K-3 are required for every pass-through entity return unless the pass-through entity has knowledge that a part (or parts) are not relevant for the partner/shareholder. It is important to note that the applicability of Schedules K-2 and K-3 is determined part by part in the schedules—it is not an all-or-nothing approach.
The IRS is trying to standardize the mechanism of reporting to facilitate tax compliance among taxpayers, because after the Tax Cuts and Jobs Act was implemented, the IRS realized there was a major gap in reporting from the pass-through entity level to the ultimate taxpayer. With the Schedules K-2 and K-3, partners and shareholders will now receive information in a consistent manner from all partnership and S corp investments.
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